By Kristen Haunss
NEW YORK (LPC) - Recent volatility in the U.S. leveraged loan market has increased concerns about diminished recoveries as regulators ratchet up criticism of the asset class.
Recoveries for first-lien loans are forecast to be about 61 percent, down from the average historical recovery of 77 percent, according to Moody’s Investors Service. Recoveries for second-lien loans are forecast to be just 14 percent, down from the average historical rate of 43 percent.
The pessimistic forecasts come as regulators express concern about underwriting quality as market volatility increases. A benchmark of 100 of the most widely held loans fell 292bp since the start of November to 95.43 on Wednesday, the lowest level since February 2016 when both the equity and credit markets were pressured by the economy and lower oil prices.
“When you think about the next downturn, leveraged loan recovery values are a concern,” said Andrea DiCenso, a co-portfolio manager for the alpha strategies team at Loomis Sayles. “It has me questioning, are the recovery values we used to assign to them kind of moot at this point?”
SENTIMENT SHIFT
The $1.1 trillion US leveraged loan market is a hedge to rising interest rates because the debt pays investors a coupon plus the London interbank offered rate. As rates rise, so do the distributions lenders receive. This is an attractive investment as the Federal Reserve (Fed) continues to raise rates, hiking them on Wednesday for the ninth time in the last three years. The U.S. central bank has indicated that pace will slow in 2019.
The U.S. loan market has almost doubled in size since 2008, buttressed by the $582 billion U.S. Collateralized Loan Obligation (CLO) market, the largest buyers of the debt, which set a new issuance record in 2018 with more than $126 billion arranged.
The uptick in CLO volume as well as investments in loan mutual funds and separately managed accounts allowed companies to cut borrowing costs and loosen document terms, including removing lender protections.
More than $585 billion of U.S. institutional loans were arranged in the first three quarters of the year after a record $923.8 billion was issued in all of 2017, according to LPC data. About 73 percent of the leveraged loan market is covenant-lite.
Former Fed Chair Janet Yellen, Senator Elizabeth Warren and the Bank of England have all expressed concerns about the loose underwriting as market sentiment has deteriorated.
Loans have a negative 2.6 percent performance since the start of November, and banks have had to widen pricing and tighten document terms to entice investors.
JP Morgan deepened the discount on a loan for aviation company XO Management to 93 cents on the dollar this month, the lowest original issue discount since the fourth quarter of 2016, according to LPC data. Some companies have chosen to pull or postpone their deals all together, including Ulterra Drilling Technologies, which delayed syndication of a loan backing its buyout by Blackstone (NYSE:BX) Group, and information technology services provider ConvergeOne, which postponed to January syndication of a facility to back its buyout by CVC Capital Partners.
Business Development Companies (BDCs), investors in the middle market, have not escaped the volatility. The average share price to net asset value across the public BDC universe has plummeted to 0.796 times as of Tuesday’s close, the lowest level since early 2016, according to LPC analysis.
While CLO issuance has remained steady, even as tranche spreads widened, retail investors have pulled more than $6.6 billion from mutual funds and exchange-traded funds since mid-November, including $2.5 billion in the week ending December 12, the largest one-week outflow since Lipper started tracking in 2003.
Loans are notorious for their slow settlement times and Fed Governor Lael Brainard raised concerns this month about mutual funds being able to meet redemption requests, a refrain the Securities and Exchange Commission has previously expressed.
Loans settled in an average 20.3 days in 2017, according to IHS Markit. Open-end funds need to meet redemption requests in seven days.
LOAN MARKET FOCUS
Despite recent volatility, defaults have remained low, supported by covenant-lite issuance, which removes many potential triggers.
The U.S. speculative-grade corporate default rate was 2.7 percent in September 2018 and Standard & Poor’s forecasts it will fall to 2.5 percent by September 2019. Fitch Ratings says the institutional leveraged loan default rate will finish 2018 at 1.8 percent.
But danger looms as the number of companies rated B3 with a negative outlook or lower sits at 182, according to Moody’s, with about 44 percent of first-time issuers in 2018 holding a B3 corporate family rating, “the lowest rating you can get and still access the market,” according to Christina Padgett, a senior vice president at the ratings firm.
“We have more low-rated credits today than we did at the peak of the financial crisis,” she said.
If there is a significant wave of company downgrades to a Caa rating, CLOs, which typically have a cap on the percentage of assets they hold with that ranking or lower, often around 7.5 percent, can be impacted, forcing them to divert payments from the most junior fund investors, according to Algis Remeza, associate managing director at Moody’s.
The focus on the asset class comes as U.S. government agencies say they will not take enforcement action based on supervisory guidance. The move is a blow to leveraged lending guidance, updated by regulators in 2013 and treated as a rule by banks, which many attribute with keeping some terms measured.
The consequence of not taking action may be private equity buyouts that are even bigger and more highly leveraged, some market participants have warned.
Despite the recent upheaval, forecasts for 2019 are strong. Barclays (LON:BARC) is calling for $400 billion-$420 billion of loan issuance next year, dominated by merger, acquisition and buyout financing, the bank said in a November report. CLO issuance is also expected to be strong with JP Morgan calling for what would be a new record of $135 billion of issuance.