Some of Wall Street’s biggest buyers of leveraged loans are gearing up to profit from a U.S. economic downturn.
A growing number of money managers that buy the loans and bundle them into bonds are giving themselves more leeway to purchase debt made to the weakest companies. Firms like Ellington Management Group, HPS Investment Partners and Z Capital Credit Partners expect the ranks of corporations with the lowest junk ratings to grow, and believe many investors will be forced to sell loans when companies get downgraded.
These managers, which gather loans into securities known as collateralized loan obligations, are bracing for a recession even as credit markets show signs of getting less concerned about a near-term economic downturn. Prices for loans, junk bonds, and investment-grade corporate debt have all risen this year after a bout of volatility toward the end of 2018 ate into prices.
But the rise of CLOs with capacity to buy more of the riskiest corporate loans underscores how there are still risks to the economy and the credit markets that have alarmed at least some. For years, money managers and financial watchdogs have warned rising levels of leverage and weakening terms in corporate lending could potentially spark a recession.
To prepare for a downturn, investors that fund their purchases of loans by issuing CLOs are building the securities with more capacity to buy loans to the lowest rated companies, those graded in the CCC tier. Z Capital Credit Partners and HPS both just sold CLOs that can hold up to 50 percent of their loans with a CCC ranking, far beyond the 7.5 percent maximum in most CLOs.
“This investment flexibility is well-suited to where we are in the credit cycle,” said Andrew Curtis, head of Z Capital Credit Partners. “We’re beginning to see dramatic volatility in leveraged credit markets. In that kind of environment, we expect downgrades and we expect CLOs to come under pressure.”
Loans to CCC rated companies can perform well after recessions. They more than doubled in total returns in 2009, according to a Credit Suisse index. A representative for HPS Investment declined to comment.
The market for CLOs has been strong. New U.S. issuance reached a record of $130.4 billion in 2018. With that growth has come a growing number of issuers at the lower end of the credit spectrum. About 29 percent of leveraged loan issuers are rated B3, the grade just above the Caa or CCC tier, according to Moody’s Investors Service data. A decade ago, that figure was just 14 percent.
Big Wave?
That could translate to a big wave of CCC leveraged loans once the economy turns, and there’s a limited set of buyers for the loans. A large number of downgrades to that tier may leave the investors managing CLOs with too many CCC loans relative to their maximum allocation. Exceeding that ceiling may cause CLO funds to fail tests designed to protect investors, which in turn could leave managers with little choice but to sell the lowest-rated loans.