Up until the end of September, credit investors in particular and Wall Street in general had nothing but good things to say about the leveraged loan market and demand for new issuance seemed relentless, despite growing warnings from various third parties and websites such as this one. And then, loan pricing nose-dived along with prices on most other credit products starting around the first week of October, right after Powell's "neutral rate" speech...
... and suddenly complacency turned to sheer panic without passing go. But the catalyst for this wholesale dread was not so much the slump in prices as much as fund flows - i.e., observing in real time what one's peers are doing - and as we showed yesterday, they are selling, with Lipper reporting that loan funds saw a record outflow of $2.53 billion in the week ended December 12, a fitting culmination to the fourth consecutive week of selling.
And then, as if on cue, the soundbites from the very same "concerned" investors who until two months ago were rushing to rushing to 4x oversubscribe any new loan deal, preferably with zero covenant protection, mutated into a cannonade of fear.
"Having outflows that are 2 to 3 percent of the market is scary. What happens if we get 10 or 15 percent?” Distenfeld, co-head of fixed income at AllianceBernstein, said on Bloomberg TV Friday. He has long been skeptical of the market. "I’m worried if this continues, we’re going to start hearing some liquidity fund issues from open-ended mutual funds."
in addition to fears about declining rates - the primary attaction for floating-rate debt - some are worried that the bottom is about to drop out of the CLO market. As a reminder, the total outstanding volume of leveraged loans is about $1,130bn (~5.5% of GDP); of this universe, CLOs - which are repackaged corporate debt that has made up “most of the appetite” for loans - hold approximately half, or $600bn (~3% of GDP) of the total loans outstanding.
And like the broader space, while CLOs had been on a feeding frenzy for much of this year, in the wake of recent widespread market volatility and sliding prices, demand has waned, even causing some investors to pull offerings as we reported last night.
"When that changes and you’re seeing that supply demand come out of balance, who are you going to attract?” Gaffney said on Bloomberg TV. "The ones that are going to come in are probably more like me, total return, that are looking for much bigger discounts than that market has seen since 2008."
In other words, deals will get done, sure, but at much lower prices and higher yields, resulting in even tighter financial conditions as companies are forced to allocate even more of their cash flow to paying interest.
To some investors the lower prices would represent a buying opportunity and a sign that loans still have a lot of value. Others including Steven Oh, global head of credit and fixed income at PineBridge Investments, say that leveraged loans are unlikely to cause systemic risk. While leverage levels are elevated like in the last recession, interest rates are much lower, so debt service is actually healthier, he said in an interview this week.
Goldman Sachs agrees, and writes on Friday that risk from runs on bank short-term liabilities as a result of losses on leveraged loans and CLOs is low as banks now own less than 5% of the outstanding leverage loans, down from 30% 20 years ago as the share of institutional investors has risen to 90%, while their exposure to riskier junior CLO tranches is relatively little.
That does not mean there are zero liquidity concerns, however, and the biggest danger is the result of one of the biggest structural complaints about loan transactions namely the long settlement proce3ss. As Luke Hickmore, senior investment manager at Aberdeen Asset Management, said on Bloomberg TV, unlike high-yield bonds, where trades typically settle in a matter of days, loan settlement periods can take closer to three to four weeks, which can (and in times of market turbulence, will) cause prices to drop even lower. In fact, the lengthy settlement time is one of the reasons why various Wall Street banks have proposed incorporating blockchain into loan transactions, to streamline buying and selling and mitigate liquidity risks.
“The market could get very gappy in funding those outflows, so the price that is going to be offered as we get further and further into that liquidity crunch in ETFs for loans could get pretty nasty,” Hickmore said. “It’s certainly one we are watching very, very carefully.”
And with good reason: while the loan market in itself may not be a systemic risk, there is more pain to come. The reason, as Bloomberg shows, is that any time investors have pulled more than $2 billion from the slow-to-settle market, loan prices continued to sink and took months to recover. For example, in August 2011 when the US was downgraded and when the loan market was roughly half its current $1.3 trillion size, loan funds saw $2.1 billion of outflows, following just one other exit over $1 billion that year. In December 2015, they lost $2.04 billion. Both liquidations were followed by steep and lengthy price declines.
With this week’s record exodus marking the 4th straight weekly outflow, bringing the recent total to $6.6 billion, it is virtually inevitable that fresh multiyear lows lie ahead.
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