What Rhymes With GFC?

Minutes from the U.S. Federal Open Market Committee (FOMC) meetings (i.e. the Federal Reserve), can generally cure even the most stubborn insomnia. So as we parsed the most recent set of minutes (September 2018) and read through usual subjects such as how tight the labor market is, what interest rate trajectory might look like and whether inflation was picking up, we were surprised to encounter a relatively exhilarating discussion topic, namely leveraged loans (i.e. loans made to high yield/junk rated companies).

Specifically, the FOMC minutes referenced the continued growth of leveraged loans and corresponding loosening of credit standards as “reasons to be mindful of vulnerabilities and possible risks to financial stability.” Interestingly the Bank for International Settlements (BIS) also raised similar concerns about leveraged loans in its quarterly review last month, so we felt we should explore the subject a little further.

U.S. junk bond and leveraged loan issuance has surged following the Global Financial Crisis (GFC) compared to levels prior to it. The decade following the GFC has seen $10.7 trillion worth of new high yield debt issued (bonds and loans), compared with just $5.0 trillion in the decade prior (equating to a 110% increase). Looking at the average over the two periods implies that the mix of loans and bonds hasn’t changed that much (proportion of loans has increased to 74% from 70%), however this masks a significant imbalance.

The imbalance is visible when we look at the last 3-4 years (since 2014), which highlights the fact that the high yield bond market has actually shrunk, while the leveraged loan market has exploded and grown at an exponential rate for the last ~2 years. This variance is significant, as historically loans have been the safest part of the capital structure (top of the stack) and generally conservatively leveraged, while bonds have traditionally been installed beneath loans in more levered structures.

In fact the proportion of leveraged loans that have >5.0x of leverage (debt to EBITDA) is now >50% in the U.S. after dipping to ~25% subsequent to the GFC and has hit an all-time high (in addition to the market being much bigger). Perhaps even more concerning is the proportion of loans that have >6.0x of leverage, which now represents ~30% of all leveraged loans being issued. Additionally, ~80% of U.S. leveraged loans are “covenant-lite” (Q1 2018) compared to less than 25% in 2006/2007, meaning that investors have no real protections aside from their ranking in the capital structure. However, as we just discussed, given the increased loan leverage, this protection (seniority) has been significantly impaired (less junior debt/bonds). Let’s illustrate this with a simple example; A company that previously had 6.0x of leverage may have structured that with 2.0x leveraged loans and 4.0x high yield bonds, however given the significant reduction in bond issuance and growth of loans, this structure would today perhaps be an “all-loan” structure with 6.0x leverage. This of course implies the loan “asset class” is much riskier than it has been in the past as it carries a higher degree of leverage.

Source: BIS

Perhaps a natural question is, “why has the bond market become more conservative than the loan market?” Given junk bonds were created to take more risk than loans and have done so since the 1970s, it’s an unusual situation. Interestingly the answer may not be that the bond market has become more conservative, it may be that the loan market has become more aggressive. Looking at the prior charts, we can see that the timing of the exponential growth of loan issuance corresponds with an exponential increase in Collateralized Loan Obligations (CLO) issuance below, explaining where the supply has been going. It is also worth noting that CLOs are structured products akin to the infamous CDOs which were built upon risky mortgages (versus highly leveraged corporate loans in the case of today’s CLOs). As we recall all too well, CDOs are often cited as one of the main drivers of the GFC. So, it is particularity interesting that as the size of today’s CLO market approaches that of the CDO market just before the crisis occurred, one cannot help but recall Mark Twain’s famous quote, “history doesn’t repeat itself, but it often rhymes”.

Amit Nath is a Senior Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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