Amid the broad market selloff this month stemming from the OPEC-Russia dispute and the COVID-19 pandemic, leveraged loans moved in tandem with broader risk markets. The asset class is on track for its worst-performing month, with the S&P/LSTA U.S. Leveraged Loan Index down nearly 17% as the quarter nears its end, exceeding the prior worst drawdown of nearly 14% in October 2008 during the Global Financial Crisis (GFC).
As a result of the drastic selloff, leveraged loans are trading at an average price of 0.78, a drop of over 10 points in March alone. At a more granular level: 95% of the leveraged loan market is trading below 0.90; 45% below 0.80; and 12% below 0.70. Yields and spreads stand at 13.7% and 1,325 bps—more than double where they were a month ago. Leveraged loans dipped as low as 0.60 during the GFC and 0.89 during the Energy sector turmoil in 2014-16. Leveraged loans, although senior in the capital structure and having much less energy exposure than high yield bonds (approximately 3% vs. 11% in the index), have performed in line with the high yield markets so far.
Larger broadly syndicated loans—over $1 billion—along with higher-quality loans are usually the first assets sold in risk-off periods because they are the most liquid. This happened during both the GFC and the Energy sector crisis. However, there are some notable differences in the leveraged loan market now. The health of the index is stronger than it was during those earlier crises. The composition of loans used as a part of private equity financing is just over half of what it was during the GFC—important because that is viewed as a more aggressive form of lending. And the median credit quality of the index is stronger: the lower-rated (below B-) portion of the index is considerably smaller than during the GFC. Lastly, overall leverage metrics and interest coverage metrics coming into this downturn were stronger than they had been in the GFC.
While recent performance paints a dire picture, it’s important to recognize these instruments are senior in the capital structure. Strong issuers also remain in the market, more than a few of which are trading lower for technical reasons because they are the most liquid names that motivated sellers can tap for cash. Based on discussions Callan has had with non-bank lenders, opportunities are available to acquire loans to leading franchises—with quality assets, no other debt in their capital structure, low capital expenditure requirements, and strong interest coverage and liquidity profiles to withstand a prolonged slowdown—at significant discounts to par. Yields for broadly syndicated loans exceed those for high yield bonds, which are generally subordinate to loans. At these discounts it is not uncommon to see returns over subsequent periods exceed double digits. The returns for leveraged loans following the GFC (from December 2008 to December 2009) and energy downturn (from February 2016 to February 2017) were 51% and 13%, respectively.
Any commentary on the leveraged loan market would not be complete without discussing the collateralized loan obligation (CLO) market, the largest buyer of these assets. CLOs are portfolios of broadly syndicated loans that are segregated into tranches and then securitized and managed as a fund, so it is not surprising to see CLO debt tranches also trading significantly lower. To give some context, senior AAA debt tranches are trading at spread levels of LIBOR+380 basis points, according to Bloomberg data, a level not seen since the GFC. At the end of February those same CLO debt tranches were trading at LIBOR+117 bps. The same factors driving investors to sell high-quality assets—liquidity and fear of counterparty risk—are clearly affecting the CLO market.
CLO debt tranches have experienced lower levels of default than equivalently rated corporate credit. According to S&P, only 0.3% of all CLO debt tranches have defaulted since 1994. The most senior parts of the capital structure—AAA-rated tranches—have not experienced a single default, and AA-rated tranches have only experienced one. Through careful credit selection and active portfolio management, CLO managers can further limit portfolio loss rates. In addition CLO structures have improved over time. CLO subordination—the level of debt below the most senior tranche—is moderately lower than it was during the GFC. And despite a lower percentage of AAA securities for post-GFC CLOs, they are better structured as they no longer include a basket for high yield bonds, one of the outcomes of post-GFC regulations.
How can the decline in leveraged loan prices impact the CLO market? Given the economic slowdown, it would be reasonable to expect a number of credit downgrades. Some credits are likely to be moved into the CCC rating category. The amount of CCC credits most CLOs can hold is 7.5%; should this limit be breached, it would trigger the structure’s cash diversion mechanism to either divert future cash flows from the equity holders and junior debt tranches to senior tranches, or use those proceeds to acquire more collateral. This does not require managers to sell existing loans. The ultimate effect of these actions is to strengthen the structure and limit credit losses. However, the mechanics of CLO structures allow for CLO managers to take advantage of opportunities when leveraged loan prices fall.
Reinvestment periods allow CLO managers to buy and sell collateral in order to maintain or improve the credit quality of the structure. The vast majority of U.S. CLO structures are in their reinvestment period given the significant growth in the market over the past few years. Managers of structures still in their reinvestment period can mitigate default and recovery risk by selling risker credits and replacing them with stronger-performing ones (note, “equity” in CLO parlance refers not to common or preferred stock but to the residual cash flows after more senior tranches are paid). In this environment, with demand for high-quality issuers at a premium, nimble CLO managers are finding opportunities by purchasing highly discounted securities. Since CLO managers are not required to mark their securities to market daily, managers are typically not forced sellers. Strong credit managers may hold some downgraded credits if they expect them to rebound at a higher recovery value, as many did after the GFC.
Leveraged loans and senior debt tranches of CLOs appear to be flashing value at the moment. However, COVID-19 will have severe effects on corporate earnings, which will almost certainly lead to further downgrades. Defaults are likely to increase dramatically and volatility will remain elevated given the prevailing uncertainty. But this crisis is unique. Rather than being brought about by an imbalance in the financial system, it is an exogenous shock driven by a nearly unforeseen health crisis that has all but stopped top-line revenue. Central banks and national governments globally have stepped in at an unprecedented scale to support markets. These actions are already showing signs of supporting asset prices and credit market liquidity. We expect this stimulus, combined with the flexibility available to CLO managers, will likely provide a strong performance tailwind for long-term investors.