Investors signal concerns with leveraged loans
Investors are pulling back from bonds backed by riskier corporate loans, raising pressure on highly indebted companies that have enjoyed easy access to the $1.3tn leveraged loan market in recent years.
Leveraged loan investments have grown popular because they pay a floating interest rate, positioning buyers to receive higher returns as the Federal Reserve tightens policy. But with investors ratcheting back expectations of US central bank rates rises, the leveraged loan market has been losing appeal.
The impact can be seen in the pricing of investment vehicles backed by leveraged loans, known as collateralised loan obligations, or CLOs, which pool expected payments and divvy up slices, known as tranches, based on their riskiness.
The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017, according to Citigroup. As recently as November 2017, the spread was 90bp.
Lower-rated CLO tranches have also come under pressure. The spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said.
“The market is turning for loans and CLOs,” said Maggie Wang, an analyst at Citi. “Both markets have struggled as people think the upside is now less because the Fed is getting close to the end of its rate hiking cycle.”
Concerns about leveraged lending were highlighted this week when Janet Yellen, the former Fed chair, reiterated warnings that declining underwriting standards for corporate loans could lead to more bankruptcies and prolong the next economic downturn.
But the current tremors in the CLO market seem more related to diminishing investor appetite than a deterioration of underlying credits. CLO issuance this year has hit a record $125bn, according to LCD, a division of S&P Global.
Investors pulled $1bn from the asset class for the week ending December 5, bringing outflows since mid-November to $4bn, according to the loan pricing unit at Refinitiv. The last time the leveraged loan market saw such large outflows was three years ago.
“The appeal of floating rate instruments has become less attractive,” said Tracy Chen, head of structured credit at Brandywine Global Investment Management. “The late-cycle credit concern, as well as the Fed’s more dovish tone, may weigh on both leveraged loans and CLOs going into 2019.”
Leveraged loans prices are down this year, but have fared better than those for more highly rated loans. The S&P/LSTA Leveraged Loan Price index has lost roughly 2 per cent this year and now sits at its lowest level since 2016. The price of Invesco’s Senior Loan ETF, by contrast, has declined 3.5 per cent.
But some CLO investors remain upbeat, blaming the price deterioration on skittish retail investors and fund managers dialling back risk as the year comes to an end.
They argue that a strong US economy is supportive of the market. Rating agencies forecast that company defaults will remain low next year.
“There doesn’t seem to be a theme of sophisticated institutional investors being worried about near-term credit risk at this point,” said Tom Majewski, chief executive at Eagle Point Credit. “If anything, the cheaper prices have started to bring more investors into the market.”