Credit Wasteland - Leveraged Loan Speculation Explained

When credit and interest rate concerns enter the scene, it is often a good time to look for value among quality fixed income investments. Instead, some market participants have advised investors to chase yields in even riskier areas of the market. We cannot help but see this as a recipe for potential disaster. One of the areas of the market investors have been told to chase yield is in the leveraged loan market. We have never suggested this asset class or equivalents because they carry more risk than typical fixed income investor desires or, frankly, should have. In spite of that fact that they are loans, leveraged loans are very risky investments. So as not to convey bias, here is Investopedia’s definition of a leveraged loan. “Leveraged loans for companies or individuals with debt tend to have higher interest rates than typical loans. These rates reflect the higher level of risk involved in issuing the loan. In business, leveraged loans are also used in the leveraged buy-outs (LBOs) of other companies.” It is the high interest rate which attracts investors. Salespeople will point out that loans are senior even to senior bonds. However, what many salespeople leave out is that these companies are so risky and have such poor debt coverage they cannot borrow in the unsecured corporate bond market. Instead, they issue loans to sophisticated investors who demand a high interest rate AND a claim on hard assets (equipment, buildings, inventory, etc.) That sounds encouraging until you realize that if the company failed and its assets liquidated, it is unlikely that creditors would receive “full value” for the assets during a distressed sale. However, sophisticated investors understand this. They may be willing to lend to a business at a rate of, let’s say, 13.00%. The investor does his due diligence and figures out that, if the company filed for bankruptcy, 50% of principal should be recovered. The investor might calculate that, by the time the company is likely to default the total return on the loan might be 8.00%, when the principal haircut is included. This might me alright for the sophisticated investors, but might surprise the heck of your average individual investors. For this reason, most individual investors cannot directly engage in leveraged lending. Wall Street, being what it is, has found a way around this. There are mutual funds and ETFs which invest in leveraged loans. Individuals can buy the fund shares. The funds, being sophisticated investors, buy the loans. Now borrowers with low credit qualities can tap a broader range of investment capital. This is a good solution, right? Maybe it is, maybe it isn’t. When investors purchase shares in ETFs and mutual funds which invest in leveraged loans, they are not investing in the loans themselves, only in the entity which is speculating in the loans. You, the investor, are not a creditor of record for those loans. If the leveraged loan market collapsed and a fund failed, you only have a claim in the fund as a shareholder. Although that is a frightening thought, it is not our biggest concern as it is fairly unlikely. Our bigger concern is one which is similar to our concerns about bond funds. When buying a leveraged loan fund, of any kind, you have no maturity. Because of investor capital flowing in and out of funds, the fund manager may not be able to hold loans to maturity or recovery. When and if the junk markets (and leveraged loans are very much junk) decline, investors may pull their money out of the leveraged loan fund. This means that the fund manager must sell some assets if he does not have a sufficient cash position. When market conditions change in this way, fund managers usually have to rebalance by selling assets. The result is that a fund manager may have to sell loans into weakness, whether or not he or she believes that to be a prudent move. The reverse is true in the current environment. Fund managers must purchase assets, even if they are richly-priced as new investor capital flows in. Do you think this cannot happen? Just look at what happened during the housing bubble. Investment managers, municipal fiduciaries, pension fund boards, etc. poured money into mortgage-backed vehicles. Few did their proper due diligence. Investors, managers and marketers relied on statistical models which told them that there was still value in these assets even late in the game. All the models said that mortgage assets were priced cheaply for their risk. This was not the case. It might not be the case with leveraged loans. We believe that there is little room for improvement in the junk fixed income markets. Investors, who purchase funds which speculate in this area of the market, could be locking themselves into a buy high/sell low scenario. However, this is just our opinion. It is an opinion formulated from decades of fixed income markets experience, but it is an opinion nonetheless. What is not an opinion is the very low quality of leveraged loans. Marketing professionals harp on the fact that these are loans and senior to bonds. It has become de rigueur for marketing types and even some sell-side strategists to point out that these loans are trading cheaply compared to junk bonds. Rather than seeing this as a “market inefficiency,” we see this as reflecting a very efficient market. In this time of great thirst for yield, asset value dislocations rarely happen on the cheap side. There is a reason that leveraged loans seem cheap to junk bonds. Although loans are senior to bonds within corporate capital structures, a leverage loan issued by a company with a poor credit rating can be more risky than a senior note issued by a company with a better credit rating. Let’s put this more bluntly. Buying leveraged loans could be akin to buying debt secure by real estate which is comprised of toxic waste dumps. If the company fails, the real estate is all yours, enjoy. Now, some of these toxic waste dumps may be worth something, but that is a speculation. Leveraged loans, whether or not they are inside funds, are total return speculations for aggressive and sophisticated risk takers. We are more than happy to discuss any and all fixed income securities, strategies and events with our subscribers. One need only give us a call or send us an e-mail. There are few matters with which we are unfamiliar. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.