For much of the past year, leveraged loan investors have been pushovers. Now, they’re showing signs of pushing back.
Money managers have demanded better terms on a spate of deals this week, including a $1.475 billion loan for the buyout of chemicals company SI Group. Prices for the debt have fallen in August. And underwriters had to boost rates on 16 percent of the leveraged loan deals they were syndicating to lure investors, data compiled by Bloomberg show, known as “flexing.” That’s the worst since 2015, when oil prices were nosediving and credit markets broadly sold off as they braced for Fed tightening.
The market is still strong by many measures, but cracks may be developing in one of the best performing fixed-income markets in the U.S. this year. The pipeline of loans linked to acquisitions for syndication after the Sept. 3 Labor Day holiday is about twice the size of last year’s, with about $27 billion of loans teed up as of last week, so supply is likely to be strong. Some money managers are waking up to the fact that credit risk is relatively high for all kinds of corporate debt now, said Mike Collins, senior investment officer at PGIM Fixed Income, which manages $717 billion.
“More speculative businesses are being financed in the loan market, high-yield bond market, and investment-grade market for that matter,” Collins said. “Markets are rightly pushing back on riskier transactions.”
With the Federal Reserve hiking rates, money managers have piled into investments like loans, which pay higher interest as central banks tighten, and into bundles of loans known as collateralized loan obligations. That demand has lifted the size of the U.S. leveraged loan market to around $1.3 trillion -- now larger than the high-yield bond market -- and spurred some companies to take out loans instead of selling bonds.
Reversing Trend?
But that trend may reverse as the Fed shows signs of being closer to the end of its rate hiking process, said Matt Toms, chief investment officer of fixed income at Voya Investment Management.
“There’s been a clear preference to buy floating-rate debt where investors can,” Toms said. “As we move into 2019, that’s less obvious an impulse.”
Amid the strong demand, money managers for much of the year agreed to weaker safeguards and protections on loans to junk-rated companies, Moody’s Investors Service said in a report last week. Around 80 percent of leveraged loans are “cov-lite,” meaning they lack meaningful protections against, for example, the company’s earnings falling to low levels. In 2006-2007, that proportion would have been less than 25 percent, the report said.
What’s more, companies are funding themselves with more loans and fewer bonds, meaning that when borrowers fail, there will be fewer other investors to absorb losses, and loans will likely perform worse than they have historically. First-lien lenders will probably recover about 61 cents on the dollar from bad loans during this cycle, Moody’s estimates, compared with the historical level closer to 77 cents. For the second lien, recoveries will likely be around 14 cents, compared with the 43 percent average, Moody’s said.