Can Leveraged Loans Keep Up the Pace?

Financial Times – Leveraged loan rush sees borrowers gain balance of power
As market grows so do concerns about credit quality and lender protections
Investor appetite for floating-rate debt is high as the US Federal Reserve stays on track to raise borrowing costs this year. This means companies such as Valeant have a wide open window for refinancing their existing loans — and on favourable terms. Indeed, last month the size of the outstanding leveraged loan market rose above $1tn for the first time, but such growth has brought a decline in credit quality. As Valeant boosted the size of its loan by $750m to $4.6bn, in a flexing of muscle that would have been unthinkable two years ago, it secured greater financial flexibility by loosening the covenants, or conditions, attached to its refinancing. Fund manager Paul Dlugosch, who began shifting his portfolio into loans from high-yield bonds and convertible debt more than a year ago, said that his current allocation of nearly 20 per cent is probably the highest he is comfortable with.

Summary

Leveraged loans have grown in popularity as investors chase higher yields and anticipate rising interest rates. Risk-adjusted returns for leveraged loans have bested both investment grade and high yield corporates over the past year and a half. Whether this can continue depends on bond market volatility.

Comment

Leveraged loan total returns have continued to press higher even as bouts of volatility and rising rates have buffeted other parts of U.S. credit markets. Leveraged loan performance has been typical for a Fed tightening campaign, although the length of the current tightening campaign has become extraordinary. Now pushing past 630 trading days, the current Fed tightening cycle is the longest in the fed funds rate era. The tightening campaign that began in 1977 arguably lasted longer but saw huge swings in the estimated fed funds rate, as defined by a Richmond Fed study.

The chart below shows total returns for the Credit Suisse U.S. Leveraged Loan Index during the current and three previous tightening campaigns. Total returns have nearly mirrored the 1994 campaign and are generally in line with past performance.

Prior to this year, high yield bond performance had dwarfed that of leveraged loans. Low volatility and an extraordinarily long risk-on cycle helped propel high yield returns to their best performance ever during a Fed tightening cycle. But the return of volatility and rising Treasury yields has dented high yield performance this year.

Leveraged loans, which thrive on volatility and earn their keep when adjustable rates rise, have begun to close the performance gap. After trailing the Bloomberg Barclays U.S. high yield index by 12% last November, the margin has fallen to just 8.6%.

High yield bonds have endured substantially higher volatility than leveraged loans over the course of the tightening cycle though. This means leverage loans (green line below) have outperformed on a risk-adjusted return basis since the beginning of 2017. Risk-adjusted returns, defined here as the 1-year average daily return over the standard deviation of daily returns, have plummeted for both U.S. investment grade and high yield corporate bonds since November of last year.

Can leveraged loans continue to gain on U.S. high yield? The answer depends on bond market volatility

The scatter plot below shows changes in the total return spread for leveraged loans minus high yield on the y-axis. The x-axis in the chart below shows 66-day changes in the Bloomberg Barclay’s Treasury total return index. Mark shading reflects the 66-day change in Treasury implied volatility, the MOVE index.

Leveraged loan outperformance has been more reliable given the combination of rising Treasury yields and rising implied volatility. Note the cluster of blue dots in the upper left quadrant. But even when Treasuries see positive total returns, leverage loans can outperform if volatility is rising.

Conclusion

The U.S. leveraged loan market has been an oasis of calm performance while volatility and rising yields have rocked other parts of the U.S. fixed income space. Total returns since December 2015 have been typical for a Fed tightening campaign. Whether leveraged loans continue to thrive depends on whether Treasury volatility keeps rising.