Ten years after the crisis, demands for leveraged loan offerings is once again off the charts. Portfolio managers who are seeking rising yields as the Federal Reserve hikes rates have shown unprecedented demand for recent deals, despite repeated warnings that they may be buying “at the wrong time”.
Leveraged loans are a type of debt that is offered to an entity that may already have significant amounts of leverage or a poor credit history. As rates move higher, the loans – whose interest rates reference such floating instruments as Libor or Prime – pay out more. As a result, as the Fed tightens the money supply, defaults tend to increase as the interest expenses rise and as the overall cost of capital increases.
Gershon Distenfeld, co-head of fixed income at AllianceBernstein LP and a longtime “skeptic of bank loans” told shown unprecedented demand that a good way to gauge the risk in the loan market is to look at returns when loans price too high. Currently, the average outstanding loan is priced at about 98.5 cents on the dollar. According to Distenfeld’s research of market prices between 1992 and 2018, when priced at this level, annual returns are about 2.8% for the following two years – lagging both behind 5-year treasuries and high yield bonds. And yet investors are piling in, hoping for even more generous payments, and oblivious to whether the underlying credit will be viable in a higher interest rate environment.
Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC kept it simpler: “It’s not a good time to be buying bank loans,” he stated. He also noted something we have demonstrated on numerous prior occasions: lender protections are worse than usual and there’s a smaller pool of creditors to absorb losses, and as covenant protection has never been weaker.
But that hasn’t fazed money managers who have been hungry for these leverage loans. For instance, this week, Blackstone Group tapped the loan market to borrow $9.25 billion in the US and Europe in order to buy out part of Reuters’ financial terminal business. The company was inundated with orders “far in excess of supply” for one of the biggest leveraged loan financings of the year.
