Leveraged Loans: A Ticking Time Bomb, How Investors Can Take Advantage Of This?

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Includes: BIG, FLS, FTSL, JCI, KDP, M, NWL, SNLN, SRLN, TRMB, TRN, VIA
by: Shravan Chinta
Summary

The leveraged loan market is showing comparable trends in lending standards as the subprime mortgage market.

85% of the loans are issued to risky companies with less protection for investors.

As corporate defaults become imminent, there is an opportunity for investors to short the leveraged loan market and vulnerable companies.

Leveraged loan market

The leveraged loan market is now worth $1.4 trillion, 75% higher than 2008 highs and that’s larger than the junk bond market- $1.2 trillion. Essentially, leveraged loans are borrowed by firms that are less creditworthy and below investment grade. As the Fed held rates at lower levels for a very long time, demand for leveraged loans has skyrocketed from yield-chasing investors. Companies took advantage of this and managed to issue covenant-lite loans, which will not help to improve transparency or any other underlying issues with the borrowers, thus, reducing protection.

The graph below from FT shows this trend:

Cov-lite loans

As of now, around 80% of these so-called senior loans are covenant-lite. The overall credit quality of these loans has been declining, giving investors very little protection and no longer considered as safe, although they are usually secured. Moodys says that “average quality of legal protections hits its worst ever level this year”. This allowed companies to lever as much as 5x times EBITDA compared to 3.9x pre-recession and 3.4x pre-Dotcom levels.

The primary concern is that the majority of the highly indebted and low creditworthy firms usually issue high yield bonds as a source of financing. Due to a decline in lending standards and high demand from yield-hungry investors, firms have gained access to the leverage loan market. Unsurprisingly, US default rates are currently low at 1.6%, reason because with covenant-lite loans borrowers would not be forced into default even though they are struggling but financially somewhat stable in the near term. Having a lack of covenants would prevent creditors from intervening in the risky activities that a company takes, exacerbating the risk of higher losses for investors.

With the increasing risk of a recession risk and a potential slow-down across the globe, a lot of high cyclical companies that borrowed aggressively could potentially default in 2019 and going forward, thanks to covenant-lite loans and loose lending standards. This will ultimately question the financial stability of the US and the global economy as a whole, as we experienced with subprime crisis in 2008.

The rise of non-bank lending

What’s even worse is that when banks tightened their lending standards after 2008, a vast majority of private equities, hedge funds, boutique investment banks and even pension funds have begun to underwrite loans. Regulators are worried about the rise in non-bank lending, as these entities fall outside regulatory oversight. According to Bloomberg, leverage in M&A deals funded by these so-called shadow banks rose from 6.4x EBITDA in 2015 to 7.7x in 2018, soaring beyond regulators’ threshold.

Within the non-bank lending space, evidence from Bloomberg shows that risky firms deliberately manipulate earnings estimates and cash flows to get the financing deals done. In addition to that companies excessively use a practice known as add-ons: companies cutting their projected leverage ratios after financing takeovers and buyouts with significant cost savings and cash flow generation, that are ultimately based on ambitious assumptions. Bloomberg says that around “30% of EBITDA figures used to calculate leverage loan deals in 2018 was made up of add-backs”. Ultimately, these less conservative/aggressive measures like add-backs would make LBO’s and highly leveraged M&A’s look less risky.

Add-backs vs Non-add backs

Chart from Bloomberg shows leverage levels with add-ons and without add-ons.

A lot of these highly leveraged companies have been able to pay the interest payments, thanks to tax cuts and strong US economic growth. As the US economy starts to soften in 2019 and tax cuts start to fade away, some of these risky firm’s with unhealthy balance sheets could run into trouble.

Who are buying these loans?

A vast majority of investors investing in leveraged loans are CLO’s and other institutional investors such as mutual funds and ETF’s. Data from FT shows that CLO’s currently own about 60% of the US loan market. Other holders include- Mutual funds (15-18%), Hedge funds/SMA’s (14-18%) and a small percentage are owned by insurers, banks and Business Development Companies (BDC’s).

CLO’s pose a critical threat to the stability of the financial system and a systematic risk to the broader economy. Globally, there is currently $700 billion worth of CLO’s with $100 billion worth of new issues every year. Those figures were closer to subprime CDO volumes in 2008. The structure of the CLO’s is broadly similar to CDO’s, where they are sold in tranches with waterfall payment structures. The CLO’s are as risky as the CDO’s, considering that the credit quality of the underlying loans is issued to low creditworthy companies: non-investment grade and high leveraged. Although loans within CLO’s are diversified, yet, compared to mortgages corporate loans are typically larger in size and fewer in number. This substantially increases concentration risk, bearing in mind that most of the covenant-lite loans are borrowed by high cyclical firms that are sensitive to economic cycles, increasing the risk of default as the economic conditions dampen.

Investors are starting to worry about the leveraged loan market. Data from Seeking Alpha shows that loan mutual funds and ETF’s AUM has drooped 16% by the end of 2018, and the leveraged loan index dropped 3%. In the event of a default, institutional investors such as insurers, pension funds, money managers and banks may be forced to sell CLO’s due to rating downgrades and losses. On top of that, mutual funds and ETF’s investing in leveraged loans has tripled since 2008, and they allow for immediate redemption, further worsening write-downs and losses for these loans. However, as of now, the market remains relatively stable due to higher risk appetite and Buy/Hold nature of institutional investors.

A large proportion of Institutional investors distorted the true price discovery of leveraged loans, unlike high yield bonds. This is because the majority of the loans are repackaged into CLO’s and almost half of the CLO’s are bought by Japanese banks and the US financial institutions. Most of the Japanese banks are buy and hold investors and less likely to sell only unless if outright defaults become probable. This has caused CLO spreads to remain low, thanks to Japanese banks. Bloomberg says that without the demand from Japanese banks, the CLO’s spreads would likely widen back to at least 2014 levels.

Shorting ETF's

On a broader level, the leveraged loan market remains a key threat to the global economy. Repackaging these covenant-lite/high-risk instruments into CLO’s could amplify the next recession, potentially causing a global financial contagion. If defaults become imminent, there are five loans senior ETF’s that investors could short and profit from:

Symbol

ETF Name

Total Assets ($MM)

YTD

Avg Volume

Previous Closing Price

1-Day Change

SNLN

First Trust Senior Loan Exchange-Traded Fund

$456.34

3.24%

255,721

$17.52

-0.45%

FLBL

Franklin Liberty Senior Loan ETF

$57.53

3.9%

645

$25.08

-0.28%

SRLN

SPDR Blackstone/ GSO Senior Loan ETF

$2,329.66

3.8%

1,003,671

$45.96

-0.39%

FTSL

First Trust Senior Loan Exchange-Traded Fund

$1,591.69

4.76%

308,308

$47.13

-0.17%

BLKN

Invesco Senior Loan ETF

$5,684.72

4.31%

8,046,594

$22.45

-0.88%

Companies on Negative watchlist by the S&P and Moody’s

Below, I have put out a list of high leveraged investment-grade companies that I believe could face issues with debt repayment/interest payments or the ability generate enough cash flows, in the face of softening the US economic growth. However, I would highly recommend investors to conduct their due diligence before considering shorting these stocks. Depending on accessibility, investors can also use loan credit default swaps (LCDS) on the underlying loans. More info on this instrument can be found on S&P.

Company

Key Info

Risks

Newell Brands (NWL)-

MarketCap:$6.4B(MidCap)

Industry: Household Durables

Leverage: 3.5x

Rating: BBB-

- S&P says that NWL continues to face challenges in regards to inflationary pressures, changing retail landscape, the bankruptcy of Toys R US and competition

Johnson Controls International PLC (JCI)

MarketCap:$33B(LargeCap)

Industry: Building Products

Leverage: 3.1x

Rating: BBB+

- Divesting Power business to pay off debt, instead of deleveraging via improved cash flows. Even after that, leverage could remain high.

Keurig Dr Pepper Inc (KDP)

Market Cap:$39.1B(Large Cap)

Industry: Beverages

Leverage: 5.6x

Rating: BBB

- Leveraged increased after Keurig acquired Dr Pepper Snapple in July 2018

- ROIC below WACC, after adjusting for non-operating and unusual items. Further analysis can be found on Seeking Alpha

- KDP operates in a highly matured industry.

Big Lots Inc (BIG)

Market Cap:$1.4B (Small Cap)

Industry: Multiline Retail

Leverage: 2.5x

Rating: BBB-

- Competitive pressures

- Elevated Inventory levels after US tariff hikes

- Intense price competition from the grocery stores, dollar stores and e-commerce is pressuring BIG’s margins

- Declining comparable store sales and EBITDA margins

Macy’s Inc (M)

Market Cap:$7.3B(MidCap)

Industry: Multiline Retail

Leverage: 3.5x

Rating: BBB-

- Recent markdowns in inventory to clear high inventory level.

- Shifting consumer preferences from brick-and-mortar to e-commerce.

Viacom Inc (VIA)

Market Cap: $9.3B (Mid Cap)

Industry: Entertainment

Leverage: 3.7x

Rating: BBB-

- Changing television market trends and cable network.

- Could lead to a decline in advertising revenues

- There are increased risks with CBS/VIA merger if it goes through. It’s likely to create more problems and could destroy shareholder value. Further analysis can be found on Seeking Alpha.

Trinity Industries Inc (TRN)

Market Cap:$2.8B(MidCap)

Industry: Machinery

Leverage: 3.6x

Rating: BBB-

- Aggressive financial policies.

- Interest coverage at 1.7x

- Completed a $500 million share repurchase program through loan borrowings

Flowserve Corp (FLS)

Market Cap: $5.7B (Mid Cap)

Industry: Machinery

Leverage: 2.8x

Rating: BBB-

- Losing market share

- Margins under pressure

- Declining ROIC

- Sales growth is 3% lower, compared to competitors average

- Increasing Days Inventory on Hand

Trimble Inc (TRMB)

Market Cap: $9.9B (Mid Cap)

Industry: Electronic Equipment, Instruments & Components

Leverage: 3.6x

Rating: BBB-

- Lev increased from 1.6x to 3.6 after the close of the recent acquisition.

- Weakening credit ratios.

- The acquisition could have integration risk of the new unknown customer base. This could delay the deleveraging process says S&P.

Sources: Morningstar, S&P, and Seeking Alpha

Closing Remarks

It is very important for investors to be aware of the holes in corporate lending space and the risks it poses to the US economy and global financial stability. I would highly recommend investors to look out for companies that have aggressive financial policies and making aggressive acquisitions. As the economy slows down and cracks in the leveraged loan space start to appear, its an opportunity for investors to short the loan ETF's, financial institutions that are heavily exposed to leveraged loans and companies itself.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.