Tuesday, August 27, 2019

Investment Insights

The U.S. leveraged loan market: risk or rhetoric?

By Nick Gray and David H. Lerner/Shenkman Capital Management

With recent media focus on the leveraged loan market, misconceptions have surfaced surrounding the asset class. 

Politicians and pundits have raised concerns over this market’s size and growth, structural features and perceived similarities between CLOs and CDOs. These claims deserve further analysis.

Press coverage of the loan market has increased in lockstep with its growth, as loans outstanding more than doubled since the end of 2012. The loan market has gained steam on the $1.7 trillion US high yield bond market, after being less than half its size 10 years ago. While this growth is substantial, loans comprise less than 5% of the total fixed income markets and are a fraction of the size of the $5 trillion investment grade bond market, and the loan market has grown by 7% annually from 2008 to 2018, versus 17% for the BBB corporate bond market. 

Click image to enlarge chart. As of December 31, 2018. Annual Update. Source: J.P. Morgan Research.

With this context, we do not believe this growth is cause for concern, and in fact see certain benefits including more diversified issuance, improved liquidity, and better access to the capital markets for more companies.

Worries over declining covenant quality are perhaps the most prevalent. Although cov-lite issuance has risen to 80% from less than 20% pre-crisis[1], we believe these concerns may be misunderstood as cov-lite refers to the absence of maintenance covenants, not no covenants. In fact, like corporate bonds, loans possess other significant incurrence covenant protections. Ironically, a new issue loan with maintenance covenants in today’s market typically conveys greater issuer risk. Additionally, senior bank loans typically enjoy a priority claim over other debt in the capital structure while often being secured by the issuer’s collateral.

Fixed Income Market Composition

Click image to enlarge chart. As of July 10, 2019. Source: Barclays

The rising popularity of CLOs has also landed this asset class in the media’s crosshairs. CLOs are long-term vehicles that provide stable capital to the loan market and have long been its primary funding source, currently owning more than 60% of issuance. Now a $700 billion market, CLOs have drawn comparisons to CDOs despite meaningful differences whereas CDOs comprised of static portfolios of securitized mortgages which played a material role in the Great Financial Crisis, “CLO structures are much sounder than the structures that were in use during the mortgage credit bubble,” according to Jerome Powell.[2] 

Institutional New Issue Cov-Lite Loans

Click image to enlarge chart. As of February 28, 2019. Source: Morgan Stanley, LCD.

CLOs have many distinguishing features, including their composition of actively managed, continually monitored, and well-diversified pools of loans. In stark contrast to CDOs, CLO debt tranches have performed extremely well from a principal loss perspective. While the cumulative default rate of all U.S. CLO tranches rated by S&P since 1994 is only 0.38%, and AAA CLO investors have never experienced a default, the estimated 10-year cumulative loss rate of AAA global CDOs over roughly the same period was nearly 29%.

Standard & Poor's Rated U.S. CLO Tranches 1994-2018

Click image to enlarge chart. Source: Standard & Poor's Research. Includes all U.S. cash flow CLO tranches have ever been rated as of 7/31/2018. Default rate = number of ratings that had ratings lowered to D/total number of ratings.

Each of these CLO defaults was from pre-crisis issues, whereas post-crisis CLO structures are more conservative as they feature additional credit support and less leverage, restrict purchases of certain assets including structured finance issues, and have shorter reinvestment periods.

Estimated 10 Year Cumulative Loss Rates by Original Rating, 1993-2016

Click image to enlarge chart. Source: Moody's, Wells Fargo Securities.

Additionally, first-loss risk is more likely to be provided by non-bank investors, which should limit the potential for systemic risks.[3] Because CLOs are funded by long-term, locked-up capital, they may act as a “shock absorber” in times of loan market stress, as managers are not forced sellers and may be incentivized to purchase discounted loans to enhance equity returns.

2006 Median Structure BS CLO

Click image to enlarge chart. As of 12/31/2018. Source: LCD, Wells Fargo.

Regulators’ primary concern appears to be the potential for the leveraged loan market to cause systemic risk to the financial system, but many experienced financial leaders think this is unlikely and regulators have, for the most part, prudently distinguished credit risk from systemic risk.

2014-2018 Median Structure BSL ClO

Click image to enlarge chart. As of 12/31/2018. Source: LCD, Wells Fargo.

We concur, that the financial system as a whole looks markedly different today than it did in 2007 with respect to the leveraged finance markets, and do not believe it will cause broader financial market instability. In our view, loans and CLOs are proven asset classes that warrant consideration in a prudent investor’s portfolio. We believe a benign default environment should persist, but macroeconomic and political concerns are present. As such, active management is paramount, and a deep dive into credit is essential. We remain highly selective and cautious with respect to our portfolio construction and aim to avoid pockets of excessive risk in the credit market.

[1] S&P LCD
[2] Federal Reserve
[3] LSTA

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Shenkman Capital Management nor TEXPERS, and are subject to revision over time. 

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