At first glance, the comparison seems apt: a roaring market for junk loans used to create securities with three-letter acronyms, sliced into high-grade tranches and sold to yield-hungry investors.
A decade on, some see echoes of the financial crisis in leveraged loans, which officials at the Bank of England have compared to subprime mortgages in 2006.
The parallels are eerie. Leveraged loans made to sub-investment grade companies have more than doubled in the past decade, to $1.3 trillion – equivalent in size to the US subprime mortgage market in March 2007. Credit quality and underwriting standards have deteriorated as the market has grown, and debt multiples have ballooned. Collateralised loan obligations (CLOs) have then turned this dubious debt into high-grade securities, which ends up on the books of banks and insurance companies.
Putting all of that together, investors could be forgiven for grabbing their tin hats and running for the hills. But, bad as things might sound, it would take an extraordinary turn of events for institutional investors to lose money on CLOs. The BB tranche of the median CLO issued since 2014 has a credit support level of 7.8%, compared with 5.6% for 2006 vintages. If loan losses in the CLO structure exceed that threshold, equity investors are wiped out and holders of the lowest-rated notes would see red ink.
That’s highly unlikely. During the financial crisis, the default rate for broadly syndicated leveraged loans peaked at 12% in 2009, according to Fitch, while data from Credit Suisse shows recoveries dipped to 43.2%, resulting in losses of 6.8%.
Some say recoveries on the current batch of leveraged loans could be far lower – around 35% – due to higher average debt multiples of five times earnings and the near-removal of unsecured, subordinated debt, which served as a loss buffer for senior debt. But even then, loan losses would top out at 7.8% if defaults hit 12%, barely singeing investors in the BB notes.
That doesn’t mean concerns over leveraged loans and CLOs are unwarranted. Analysis rooted in historic data – such as the 12% peak in defaults – often fails to account for recent market changes. In this case, the CLO market itself has doubled in size since 2013, giving it a precarious appearance.
Along the way, sub-investment grade companies – which run the gamut from cash-burning tech disrupters such as Uber, to past-their-prime retailers like Neiman Marcus, and everything in-between – have come to rely on the cheap financing provided by big CLO investors, who are willing to accept the higher debt multiples and weaker covenants. If the economy went into a lull and defaults started ticking-up, though, that demand could dry up, leaving companies that need to refinance with nowhere to go.
“Everybody is going to sit by the sidelines,” says one CLO investor, “but the company with maturing debt can’t sit by the sidelines. That now becomes a default, even if their earnings are still strong.” Around half of the newly issued leveraged loans are used to refinance existing debt.
If CLO investors did take flight, those companies would be starved of credit, causing the default rate to spiral further, possibly beyond historic levels.
The good news is that relatively few leveraged loans will come due in the next three years, as companies bulked up on loans ahead of the Federal Reserve’s rate hikes. Only $123.4 billion of loans will mature before the end of 2021, according to Fitch. More than half the loans currently outstanding – $682 billion – come due in 2024 and 2025.
That’s some time off. But if investors do lose confidence in CLOs, the market could be sucked into a vicious circle.