Welcome to the Tortoise QuickTake podcast. Thank you for joining us. Today, senior members of Tortoise provide a timely update on trending topics in the market.
Welcome to this week’s Tortoise credit podcast. I’m John Heitkemper, portfolio manager for high yield bonds and leveraged loans at Tortoise.
The significant growth of the leveraged loan market proved to be a major topic in leveraged finance – and in the broader financial world - during 2018. It seemed that a week didn’t go by without a big name in finance, whether it be Janet Yellen, any number of current Fed officials, or the IMF, sounding the alarm that the loan market had grown too large, too fast while letting protections for creditors deteriorate. With the size of the loan market eclipsing the high yield market, which contracted for the third straight year, many prognosticators suggested that loans might play a part in the next financial crisis. Flip the calendar forward to 2019, and circumstances appear to have changed. With demand for leveraged loans down, for reasons that we’ll go into later, leveraged finance issuers have increasingly turned to the high yield bond market and to secured bonds, in particular. To the new issue-starved high yield market, this is a welcome turn of events.
What many observers may not realize, particularly those prone to writing doomsday headlines, is that while potential issuers of bonds or loans might prefer one market to the other, they are going to go where the financing is easiest and least expensive. Let’s face it, they’re not all that different from my kids, who when they want something, will first ask my wife. After she says no – she’s the better parent after all – they’ll sneak up to me, exuding phony innocence, and ask for the same thing, knowing that if I’m distracted or oblivious to their schemes, I might slip up and say yes.
For the past couple of years, that’s what the loan market has been doing – saying yes. To issuers that want to pay dividends to their private equity sponsors or engage in highly leveraging M&A, the loan market has said yes. To issuers asking for covenant-lite deals with weak documentation, the loan market has said yes. To pretty much any request from an issuer, the answer was yes. What made this trend possible, of course, is nearly insatiable demand for leveraged loans from CLO managers and retail loan funds, which in turn experienced strong underlying investor interest in floating rate products.
But in 2019, two trends have changed, resulting in weaker demand for leverage loans. First, as a result of the volatility at the end of last year, CLO creation is off to a slow start, down over 60% compared to 2018, according to Citigroup. Recall, CLOs typically buy about two-thirds of leveraged loans, so a slowdown in CLO creation definitely causes a dent in loan demand. Secondly, the Fed’s rather sudden shift to dovish language has altered the market’s forecast for the future path of interest rates, undermining the demand for floating rate products. Back in November, the market priced in another Fed hike in 2019, which would imply that Libor, the floating benchmark for loans, could continue its ascent. With the Fed’s recent signal that it’s on hold for the time being, the forward Libor curve has rolled over, suggesting the Fed’s next move might actually be a cut. Floating rate products, loans included, are no longer in vogue, with retail loan funds losing a substantial $17.5 billion, or 16% of AUM, over the past 12 weeks.
Although weaker technicals in the loan market pose a challenge for issuers, the good news is that after losing share to loans over the past few years, the high yield market stands ready to take up the slack, having taken in about $8.5 billion in retail flows year-to-date. The relative strength in high yield technicals explains the significant shift of supply from loans to high yield in 2019. At the beginning of 2019, high yield issuance as a share of overall leveraged finance deals is at a three-year high, and in particular, issuers are utilizing secured bonds to finance the part of their capital structures that would have otherwise gone to the loan market. In fact, according to Barclays, about a third of this year’s high yield issuance is secured, the highest percentage since 2009, when the loan market was essentially left for dead after the financial crisis.
Much of the recent secured bond issuance has come from large M&A or LBO financings, including Commscope’s $2.75 billion 2-tranche secured bond offering and Transdigm’s $3.8 billion secured bond, the single largest high yield secured bond ever issued. In the Commscope financing, the company also issued $3.2 billion of leveraged loans with the same collateral as the secured bonds, but at a yield in excess of 6%, the loans actually priced wide to the secured bonds. That was also the case for Dun & Bradstreet’s LBO financing, which saw the secured bonds price inside of 7% and the loans in excess of 8%, which speaks to relative strength of the high yield market compared to the loan market.
We think the recent trend in secured bond issuance probably has room to run from here, as it normally takes loan market technicals some time to rebalance. If the Fed really is done raising rates for this cycle, the new normal in loan demand may be significantly lower than the recent past, and issuers had better hope that the high yield market remains accommodating. Nothing starts a temper tantrum faster than getting told no twice, and that goes for kids and issuers alike.
Thanks for listening, and please tune in for future Tortoise credit podcasts.
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Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.