Corporate America has taken on substantially more debt in the aftermath of the Great Recession. Today, the underlying structure of that leverage looks different. Fewer bonds are being issued. Bank loans to indebted companies now match junk bonds in total issue. This article will review the market for leveraged loans - a marketplace that has grown tenfold in the new millennium and has passed the $1 trillion threshold.
A leveraged loan is a commercial loan provided to a borrower that has a non-investment grade rating. The Bank of England concludes that the leveraged loan marketplace may be nearly twice the size of that tracked in the S&P/LSTA index - the headline benchmark for the asset that is charted above.
Levered loans typically have no call protection. In fact, most are continuously callable at par value. In 2017, nearly 70% of levered loans were refinanced at lower interest rates. That creates a lot of turnover. Junk bonds are also callable, but typically during restrictive time frames at prices well above par.
The interest rate is variable, with reset periods every 3 months. Rates are quoted at some spread to a common benchmark like LIBOR. Thus, levered loans have very short durations. Many investors concerned with recent Fed policy favoring rate hikes are attracted to the variable interest rate.
Keep in mind that bank loans are a private transaction between the bank and the borrower.
Loans typically have fewer market makers than do high yield bonds. Loans ...have less regulatory involvement and oversight compared to bonds. ... the disclosure of financial information is limited only to holders and potential qualified investors. Furthermore, loan issuers may not file any public financial information, making it more challenging for outside investors to monitor and track information related to this asset class.
Bond trades typically settle within two days. Leveraged loan sales settle in about 17 days with some trades taking as long as two months. This creates difficulties with the valuation and portability of managed loan portfolios. Let's look at the investment vehicles currently in place for leveraged loan product.
About 45% of originated leveraged loans are repackaged as Collateral Loan Obligations (CLO) and marketed to institutions and qualified investors (e.g. family offices). The CLO structure carves cash flows from the collateral into tranches prioritized ahead of a residual equity interest. The senior tranches are typically allocated to pension funds and insurance companies with little tolerance for risk. Professional asset managers often take the residual interests, which offer the highest expected returns and bear the brunt of losses.
There are easier ways for retail investors to take a position in this space. For example, there are at least 30 mutual funds that consist primarily of leveraged loans. The vast majority are actively managed. Expense ratios are around 1.0%. There are also at least five ETFs in the leveraged loan space. One of the largest, Invesco's senior loan ETF (NYSEARCA:BKLN), attempts to track the S&P/LSTA U.S. Leveraged Loan 100 Index at a net management fee of 0.65%. The higher fee may be attributable to the churn within the index and trading difficulties associated with its underlying components. Competition may eventually drive the cost of ownership down as it has with other asset classes.
The stated yield to maturity of BKLN is 5.78%. However, most of the underlying loans have call features. Might be more realistic to use the ETF's SEC yield as a metric for anticipated return. It's a bit below 5%. That's still substantially higher than short-term investment grade fixed income products.
Before wading into this comparatively new asset class, it is reasonable to ask whether it really adds value at the margin to an otherwise diversified portfolio. That is difficult to determine given the relatively short tenure of the leveraged loan space.
I compared the performance of the BKLN index ETF with a short-term junk ETF (NYSEARCA:SJNK) that tracks the Bloomberg Barclays US High Yield Cash Pay 0-5 Year Index. It is an investable index that is probably the closest match to leveraged loans.
The results were promising but hardly conclusive. The newer security, SJNK, started trading in April 2012. BKLN started trading a year earlier. There is therefore 7 years of joint history. Thus far, price movements have a high 0.81 correlation. Returns and volatility are below.
Given the very short reset periods on interest rates with leveraged loans, it is not surprising that its volatility and returns are a bit lower than the junk bond fund. One could make the case that any portfolio that includes junk bonds should also consider some allocation to leveraged loans.
The leveraged loan space distinguishes itself from the preferred stock market in that it enjoys a high level of industry diversification. A while back, I wrote a cautionary article on preferred stocks that pointed out that these senior equities were composed almost entirely of financial companies. Not so with leveraged loans. Many industries are represented, including, retail, healthcare, media, and electronics. The table below does illustrate that the industry allocation does fluctuate over time.
The leveraged loan space is sizable - over $1 trillion in product. It's still quite new, however, with major impediments to liquidity. Even with a significant number of mutual funds and ETFs providing a mark-to-market mechanism, they have not been tested under real financial stress yet. Junk bonds traded thinly during the financial crisis of 2008 and pricing was erratic. Would an asset class consisting of bespoke unregistered securities perform well under pressure? It's hard to say.
At this point, I don't feel comfortable making an allocation to leveraged loans in client portfolios. The product is too new and contains novel features atypical of traditional securities. Management fees for loan funds are still on the expensive side. That said, it's a larger body of assets and offers greater industry diversification than preferred stock. And there is certainly greater transparency than offered by subprime loans. For now, leveraged loans are on my watch list.
Anytime a new asset class has the kind of rapid growth that leveraged loans have exhibited, it is useful to ask whether this growth has created dangerous excesses in the world economy. Certainly, the growth of subprime loans proved toxic a dozen years ago. Let's step back from tactical concerns and view the context of levered loans within the whole economy.
Both the Bank of England and PIMCO assessed the systematic impact of the leveraged loan market recently. The rapid growth in the space has been driven by increased securitization activity through collateralised loan obligations (CLOs).
Most experts who follow leveraged loans have noted that protective covenants are much less common than with traditional bonds. In fact, 80% of recently issued leveraged loans are 'covenant light," meaning that traditional investor protections are absent from the loans. That's a big increase relative to five years ago. The bottom line is that lenders are demanding less of borrowers. There has been a relentless search for yield since central banks slashed interest rates during the financial crisis.
Leveraged lending has been part of an overall borrowing binge in corporate America. Gross corporate debt has increased 270% of annual earnings in 2018, close to 2007 levels.
The Bank of England noted other parallels with the subprime loan market of the early 2000s. The annual growth rates of both debt products has been around 15%. The subprime mortgage market eventually captured about 13% of the overall US mortgage market. Leveraged loans now comprise 9% of US corporate debt.
Another troubling sign is that proceeds from the issuance of leveraged loans have been used primarily for financial engineering rather than investment projects. Thus, there doesn't seem to be a direct connect between lending activity and new employment. See the table below.
There are some mitigating factors, however. Many of the buyers of subprime mortgages a decade ago used short-term borrowing facilities to finance the purchase. Today's buyers of leveraged loans have not borrowed. There is less potential for a cascading failure.
Also, there are no derivative products involving subprime loans. CLO products merely pass through the cash flows of the underlying collateral. Subprime securities themselves were used as collateral for derivative products in the 2000s, multiplying the impact on the system if subprime mortgage cash flows were compromised.
PIMCO points out ownership of today's leveraged loans is diffused. The holders of the riskiest tranches of leverage loan product are hedge funds and other sophisticated asset managers. Importantly, they are less interlocked with other sectors of the financial system as Shearson Lehman, FNMA, and AIG were a decade ago. Today's CLOs are also better collateralized than the securitized mortgages of earlier years.
The growth of leveraged loans in corporate America is a source of concern. However, it appears that the kind of securitization that has taken place poses less of a threat to the overall financial system... so far. The loss potential to investors is almost certainly less than that sustained by investors in Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) during the stock market decline in the 4th quarter of 2018.
Disclosure: I am/we are long SJNK. 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.