leveraged loans and private debt

FIGURE 1:  private lending market

For institutional investors, returns are a key attraction. One reason the market is growing particularly strongly now is rising US interest rates. As the US Federal Reserve increases borrowing costs, this has made the floating rates on leveraged loans more attractive to investors than the fixed coupons they would otherwise receive from high yield bonds.

Although the 10-year average annualised total return is still below that of listed high yield, leveraged loans have performed better when adjusted for volatility over that timeframe. This is not only because their coupons rise in line with LIBOR but also because such assets sit higher up in a company's capital structure. Such assets have also outperformed in absolute terms over 2018-to-date as rates have gone up.

FIGURE 2:  institutional dominance

US issuance of leveraged loans, banks and institutional, USD billion

But returns are only part of the allure - private debt is also becoming a richer hunting ground.  Companies operating across a broader range of industries now borrow directly from non-bank entities, partly because new regulations have forced the banking sector to scale back lending.  At the same time, companies of all stripes are borrowing more for strategic reasons. 

FIGURE 3:  overtaking high yield

Institutional AUM by asset class, USD billion

Rather than refinancing debt or recapitalising balance sheets, the majority of new leveraged loan issuance over the past five years was to fund mergers and acquisitions or leveraged buy-outs.¹ (US M&A deals so far this year have totalled a record USD2.2 trillion.)

In the US, some USD1.5 trillion of leveraged loans were issued in 2017 – 71 per cent more than the average annual issuance over the previous five years. The first half of 2018 has been similarly strong. As 86 per cent of the market is in the US,² we have largely focused our research on this region.

Within the outstanding debt held by institutions (including CLOs, loan mutual funds and real money investors), leveraged loans have overtaken high yield bonds in the US (see chart).

Outstanding private debt has also grown significantly over the same period to USD638 billion.

On the face of it, it makes economic sense for institutional investors to align long-term pools of capital with their longer-term liabilities.

But how these new providers of capital respond to defaults and credit events, such as credit rating downgrades and financial restructurings, has yet to be seen. This is a risk both for investors in the asset class and for financial markets more broadly.

The first reason for caution is the fact that credit pricing – both for leveraged loans and for high yield – now provides little room for default and recovery. The extra yield, or spread, such assets offer over US government bonds has fallen sharply in recent years (see chart).

FIGURE 4:  falling rewards

Excess spread adjusted for average default, recovery rates

The average spread at loan signing date has dropped to 383 basis points by mid-2018 from a peak of 473 basis points in March 2015.³

That matters. If defaults were to rise to 5.5 per cent from about 2 per cent currently – which would still be far short of the 10-15 per cent rates typically seen during recessions – and the recovery rate dropped to 50 per cent, the excess spread would be wiped out by the capital loss. In other words, it would take only a relatively modest deterioration in conditions for investors to lose all the additional compensation these assets are offering in exchange for increased risk and reduced liquidity.  

An additional concern is that the leveraged loan market tends to feature lower-rated borrowers, with the majority rated B, compared to BB in the high yield market. The spread per unit of leverage – how much more of a premium investors receive for choosing to invest in a more indebted company – has fallen to 76 bps, more than 25 bps below the average of the prior five years.⁴

The trend towards ever lower compensation for risk is evident across the credit market – internal rates of return (IRRs) on private credit funds have compressed in the face of rising capital inflows and increased competition for assets. Meanwhile, the spread on high-yield bonds has also narrowed significantly, a sign that markets are moving into the latter phases of the credit cycle.

Just as prospective compensation has deteriorated, so too has credit quality, with lending terms shifting firmly in favour of borrowers. 

Covenants have weakened. So far this year, 57 per cent of new leveraged loans issued have been “covenant lite”⁵ – incorporating less protection for the lender and giving more flexibility to the borrower in areas like tests on collateral, leverage, payment schedules, etc (see chart).

FIGURE 5:  less protection for investors

Covenant lite loans as % of global leveraged loan issuance

At the same time, leverage in private lending has climbed. The share of US leveraged buy-outs (LBOs) levered at six times EBITDA or higher has gone up to nearly 50 per cent in 2017 from 30 per cent in 2013.⁶

Moreover, an increasing percentage of EBITDA used for calculating leverage ratios in takeovers is based on speculative forecasting like add-back synergies from buyouts or takeovers. 

Such deterioration in companies' credit profiles has two potential consequences. First, it could lead to lower recovery rates in case of default as weaker covenants can enable companies to issue more debt than would normally be the case. Not only does that reduce their ability to pay, but it also increases the risk a loan will be subordinated by future borrowing. 

Second, it keeps companies alive for longer than may be economically viable – leading to a preponderance of “zombies” or businesses that do not generate enough earnings to cover interest costs. Zombies now account for 27 per cent of US small caps in the Russell 2000 index, up 10 per cent from ten years ago.⁷

The large volume of investor cash chasing potential investment opportunities means that returns are likely to be lower. There was USD236 billion of dry powder in private debt funds as of end-2017 (out of USD667 billion of total AUM).⁸

Any asset comes with risks, and the key to successful investment is to fully understand what those risks might be.

Arguably, the biggest problem with private credit is that the asset class is largely untested against adverse market conditions, having yet to endure a significant default cycle. 

The majority of private debt funds were created well after the financial crisis.  And, while CLOs have been around for a long time, they have recently experienced exponential growth (see chart), which we believe will likely render historical default trends irrelevant.

FIGURE 6:  increased clo presence

Global CLO issuance, USD million

The increased presence of CLOs in the market is also dragging down the aggregate credit quality of newly-issued leveraged loans, as they typically purchase B2/B3 rated bonds.

Changes in the investor base offer another dose of uncertainty. Private equity firms, which have played a major role in the growth of CLOs in particular, now manage the entire structure (which now includes the leveraged loans created to fund LBOs). If the market turns and CLO yield spreads widen, this could dry up funding for such firms. Investors would then have to write down the value of both their debt and equity investments.

Investors should, therefore, carefully consider their tolerance for risk should market conditions deteriorate. And given the impact leveraged loans can have on corporate capital structures, investors also need to think carefully about any other investments they may have in these companies.

Some industry sectors are particularly vulnerable. Consumer discretionary, telecoms and materials sectors in particular are strongly represented in the “covenant lite” leveraged loan market compared to their overall market capitalisation.

So, as the credit cycle enters its later stages, we are mindful of the risks to the bond market in general and to its private lending segments in particular. Those investing or considering raising their allocation to private credit should be cognisant that protection is weaker and returns are lower than has been the case historically. We believe that the outlook for these products – as yet untested but whose returns are likely to be highly correlated to other parts of the credit universe – is uncertain over a two- to three-year time horizon.