Caveat Emptor: Leveraged Loans and the Credit Cycle

Caveat Emptor: Leveraged Loans and the Credit Cycle

AllianceBernstein, the Nashville-based, asset management firm released a white paper on high-yield bank loans. Buying these loans seems, to some investors, a fix for the ongoing low-interest-rate environment. But the white paper is a warning. In two words, “buyer beware.” 

The paper is the work of Douglas J. Peebles and Gershon Distenfeld, respectively the CIO and co-head of fixed income at AllianceBernstein.

The Basics

Banks that make variable rate loans to risky companies sell these loans to hedge funds, mutual funds, and other investors who want the higher yields that come with higher credit risk. The instruments involved are sometimes called “leveraged loans,” given their high leverage multiples and their use in leveraging debt or finding buyouts.

They can be a valuable part of a portfolio because, like high-yield bonds, leveraged loans have historically a low correlation to traditional fixed-income investments.

But there are two key distinctions between high-yield bank loans and high-yield bonds. The former are floating rate instruments and, in the event if a default, they are senior to bonds. Both of these differences sound like pluses, they would seem to give investors in the former instrument greater protections than investors in the latter. But, Peebles and Distenfeld caution, the situation is not that simple.

Not What They Seem

As to the floating-rate distinction … yes, in principle the coupons of bank loans are adjusted based on changes in the reference rates, such as Libor or an alternative. But “bank loans don’t always behave like floating-rate instruments should.” Bank loans are callable, and of late they are often called. Roughly two-thirds of outstanding loans were trading above par at the end of 2017. Borrowers have refinanced, and that has taken a toll on dividend income.

The Credit Suisse Leveraged Loan Index performed at 4.25% total return last year, which does not compare at all favorably with the Bloomberg Barclays US High Yield Corporate Bond Index, with a 7.5% total return.

As to the protection from default—that, too, may be less than it appears. Leveraged loans have, as the white paper observes, become “the most popular way to finance leveraged buyouts—the riskiest type of corporate takeover.” This suggests that default risk may be higher than many loan buyers realize. Peebles and Distenfeld think that when defaults happen “recovery rates are likely to be a lot lower than they’ve been in the past.”

And Defaults will Come

It isn’t a matter of whether the defaults will come, but of when. And the answer to when is “soon.”

The paper cautions that the US economy at present is “in the late stages of one of the longest credit expansions on record,” and then once the cycle turns down, “both bank loans and high-yield bonds are likely to underperform.” Furthermore, the underperformance of the bank loans will be more severe than the underperformance of the high-yield bonds, because credit valuations have become stretched, as is typical of the late phase of a cycle. This means overvaluation, and this means that the downturn will disillusion investors about those values.

Investors are, in most situations, wiser to take their credit risk through bonds, not leveraged loans. Furthermore, at this stage of the cycle, investors should be tilting their own portfolio away from either of those asset classes, and toward more interest-rate sensitive instruments such as intermediate-duration Treasuries. They propose a “barbell” strategy for the whole of the credit cycle: high-yield bonds at the credit side and Treasuries at the interest-rate side.

Furthermore, investors who like floating-rate exposure might be well advised to invest in credit risk-sharing transactions, a new type of mortgage-backed security courtesy of the federal housing entities. CRTs, say Peebles and Distenfeld, are not continuously callable so they are a “different animal” from bank loans. They have outpaced bank loan returns in the face of rising rates. For example, in the period August 2016 to January 2017, the Credit Suisse Leveraged Loan Index was up 4.5%. The CRT returns in AB’s own mortgage income portfolio were up 7.1%.

The authors find little good to say about leveraged loans and nothing good to say about them at this point in the cycle.

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