- Wall Street Journal – The Unseen Risk in the Booming Loan Market
Low yields led investors to dive into loans but there are signs that the generalists are stepping away.Central bank money inflated the markets for risky loans and the investment vehicles that buy many of them. Now, there are early signs of that driving force going into reverse. In recent weeks, a growing share of new borrowers have had to lift interest rates on leveraged loans to win over investors. This might just be a touch of indigestion after several large deals to fund private-equity buyouts and takeovers, but some bankers think it is an early signal that liquidity is retreating from low-quality debt. The trouble for borrowers isn’t rising debt costs today, but the risk that loans will be harder to refinance in future when investor money washes back to safer assets as yields improve. This matters because more than 40% of leveraged loans are typically used to refinance an existing loan. In the financial crisis, even some relatively healthy companies couldn’t refinance and had to reach deals with existing lenders to extend their debt.
Summary
A renewed appetite for risky corporate bond exposure has investors pouring into leveraged loans. They are unlikely to outperform high yield bonds unless Treasury yields break free from range-bound conditions.
Comment
Investors are boosting exposure to risky corporate debt again. High yield ETFs saw over $1.8 billion in net inflows in July and nearly $800 million already in August. Leveraged loan ETFs are seeing another wave of interest as well. The chart shows net 20-day flows for bank loan funds surged to $241 million as of Monday. This is already the second largest wave of net inflows for 2018, following a surge in March and April that peaked at $670 million on April 16.
Leveraged loan performance is following a well-worn path during this Fed tightening campaign. The next chart shows cumulative total returns during the current and prior three Fed tightening campaigns. As the current tightening cycle extends past 688 trading days, leveraged loans total returns have reached 19%. The first 300 days of the tightening cycle were a near mirror image of the 1994 cycle.
We’ve commented on the relative performance of leveraged loans and high yield periodically throughout 2018. Back in May, just as the burst of net inflows in bank loan ETFs was winding down, we wondered if leveraged loans could maintain their outperformance over high yield. That turned out to be a short-term peak for bank loans and high yield has outperformed by roughly 1% since. But on a risk-adjusted return basis, leveraged loans continue to look attractive. The chart shows rolling one year reward to risk ratios, the average daily return / standard deviation of returns. Using this measure, the Credit Suisse U.S. leveraged loan index continued to offer superior risk-adjusted returns over the Bloomberg Barclays U.S. high yield index.
Whether high yield continues to outperform on an absolute return basis will depend on the path of rates and Treasury market volatility. As we detailed in a January post and webcast, the best recipe for leveraged loan outperformance over high yield is a combination of rising rates and rising volatility.
The last chart shows the smooth functions from a generalized additive model we used to illustrate this. The charts show the effect of changes in 10-year yields (left) and Treasury market implied volatility (right) on the probability that leveraged loans will outperform. Unless Treasury yields can break free of the dull range-bound conditions we’ve seen for several months, the environment will continue to favor high yield bond outperformance.