Leveraged Loans are Booming

Daniel Shainberg
September 22, 2018

The "beginning of the end" is a decent way to sum up the economic outlook for the next few years. It's always a shot from the least expected corner of politics, society or the economy that breaks the back of the bull. 

In the prior two economic busts, for example, we had all the classic warnings signs: overheated sectors (technology, housing), excess leverage driven by low borrowing rates, classic cash flow based valuation methodologies thrown out for circus metrics, and Warren Buffet laughed at for being too "old school." 

Today we have the cryptocurrency fad, the cannabis boom, a decade of low rates, excess shadow lending, bursting sovereign debt levels across the Eurozone and of course the much discussed trade war with China which just seems to be snowballing into a real issue. Then there's the rising oil prices and 10 year yields breaking every technical signal. San Francisco is another bellwether indicator as the technology industry always seems to experience elevated cyclical correlation to the economy. The city by the bay is so advanced technologically that someone actually created an app to track human feces and syringes laying on the street. These are indicators and signs of the times. 

The next bust, like previous ones, will likely be triggered from where we least expect it. That's why the timing is so difficult to nail down. Peter Schiff, Nouriel Roubini and many other economists with fancy accents have been pointing out many of these indicators for a decade and the result was the biggest boom in equities during the tenure of their preaching. 

One of the biggest signs of a downturn that also serves as a catalyst is the leveraged loan markets. In our prior article "Watch Credit Markets Not Chinese Tariffs" we highlighted how the credit markets are a bigger risk than a trade war with China. Leveraged loans are one of the few markets that actually can predict timing as corporations may extend their balance sheets, but once the cycle stretches too far, the game is up, and they have to pay their interest due. It is at that point when covenants are breached, interest payments are missed or refinancing transactions fail, that investors fall over each other to bail. 

Today, exactly a decade from the 2008 financial crises, the leveraged loan market is back to a peak. 

Investors, starved for yield and petrified of duration risk, are once again chasing the allure of income that floats with Prime or LIBOR. As interest rates climb higher, leveraged loans offer commensurate yields to their investors. But there's a price and value to every investment asset, and after the recent boom in this market, the average leveraged loan is trading near par, a level that historically offered its investors less than a 3% total return in the following two years. 

The problem is that while loans are the "safest" financial security within the capital structure, defaults can occur and recovery rates may end up being significantly lower than prior cycles. Moody's predicts that U.S. 1st lien recoveries could fall to 61%, versus their 77% historical average, and second lien loans could see recoveries drop to 14% versus a 43% historical average. 

In the current environment, like prior market peaks, creditor friendly financial covenants are virtually non-existent. The U.S. market for leveraged loans is now in excess of $1 trillion. Pension funds have been plowing in, eager to take advantage of the limited interest rate risk offered by these floating instruments. 

The key driver for the leveraged loan market this year has been the Fed's increase in rates. With the fed set to increase rates again next week, the demand for this product will likely continue to grow in the short term. 

But once investors in these products recognize the default risk, recovery risk and limited remaining return opportunity, this market can reverse and take the equity markets with it.

Dan Shainberg
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#RecessionResister
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