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Summary

  • Leverage loans are benefiting from the 'search for yield.'
  • Their return pattern is thus no longer explained by traditional factors.
  • It is yet too early to talk about a bubble. But the risks are mounting for a sharp rise in default rates once the credit cycle comes to an end.

As is well known, leveraged loans are more immune to a rise in long term interest rates than high yield bonds (floating rates indexed to US LIBOR against fixed coupons, that is, no duration risk). But what happens when yields are falling, as has been the case for the last few months?

The chart below shows that there is a positive link between the relative return of bank loans (S&P LSTRA index) against junk bonds (JNK ETF) and the change in the slope of the U.S. Treasury yield curve. The taper fear lead to an expected underperformance of high yield bonds vs. leveraged bonds. Yet, the recent flattening of the 3M/10Y U.S. Treasury curve did not lead to any significant underperformance of bank loans.

The same pattern of divergence appears if we use only U.S. 10-year Treasury yields or their implied volatility. Even the link with the S&P 500 has collapsed. Why?

The most straightforward answer could be the short end of the curve. Leveraged loans have floating rate coupons whose regular resets make them much more attractive in a rising yield environment. Given the lack of responsiveness of the long end to the short end behavior, the link between leveraged loans and junk bonds relative performance could be better gauged through the changes in the U.S. money market curve. The chart below confirms that, unfortunately, the relative performance is no longer related to the expected changes in the Fed policy. Leveraged loans "should" have underperformed much more in such an environment.

(click to enlarge)

What makes the leveraged loan market so immune to the expected changes in forthcoming monetary policy? The chart below shows that the 3-month correlation between leverage loans and many other asset classes have drastically changed over the last year: from positive to negative correlation with U.S. Treasury yields and commodities (Pending:CRB); from positive to inexistent with the S&P 500; weaker with high yield bonds.

(click to enlarge)

From an asset allocation stand point, such correlations would call for diversification. All the more since an improvement of the economic momentum would come along with higher short-term yield and low default rates - something liable to temporarily offset the risk associated with the weakening of underwriting standards of leveraged new loans (lower coupons, lighter collateral) as well as the growing leverage of new deals.

In addition, even though medium (5y) or long (10y) yields are generally negatively correlated with corporate spreads, their historical tightness makes corporate bonds (investment grades or high yield) less immune to the risk of monetary policy tightening as the potential for spread compression is limited.

This could explain the flatness of the relative return between bank loans and high yields in spite of the swings in the money market curve.

Search for Yield?

There are talks that the bank loan performance could be explained by the search for yield. To me, the term relates to a situation where the central banks is so accommodative (repo rate close to the zero bound, balance sheet expansion) that the balance of power shifts to favor of suppliers (issuers), rather than investors (skewed by the low rates stirred by the Fed policy).

The supplier's market explains the increase in leverage, the growing share of covenant-lite deals, and the merger-related loans. Yet, it is important to distinguish the search for yield and the timing of the last phase of the credit cycle: the relaxing of loan attribution can accentuate the dire consequences of the last phase of the credit cycle (mostly defaults), but not necessarily bring forward or accelerate the credit cycle.

As a result, given the ongoing signs of economic acceleration and the realization that the Fed might act sooner than later, bank loans will remain attractive as an asset class. However, investors should keep in mind that the associated forthcoming drawdown is growing as time goes on.

Bottom Line: The relative insulation of bank loan returns would call for an appealing attractiveness in terms of asset allocation, especially since, in the short run, the macroeconomic landscape would call for higher yields and stronger growth (low level of default rates). Yet, the ongoing "search for yield" is providing more power to issuers, paving the way to a difficult late phase of the credit cycle. But this should not be a story for 2014.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: A Bubble In The Leverage Loans Market ?