On the surface, the leveraged loan and CLO markets appear to be as robust and healthy as they have ever been.
But scratch the surface and there's a percolating anxiety about some of the market fundamentals.
“It’s difficult to argue with how rosy the numbers look” in macroeconomic terms, said Farboud Tavangar, a senior portfolio manager at LCM Asset Management. But in terms of risk management, both CLOs and the below-investment-grade companies they invest in are “far more aggressive than they were pre-crisis,” he said at an industry conference Wednesday.
Tavanger ticked off a list of concerns: The accumulation of loans with loose covenants, allowances for share repurchases or allowances for borrowers to avoid using asset sales to repay debt. All are examples of corporate borrowers pushing the envelope with lenders and investors. As a result, leverage may be higher “than meets the eye,” given the EBITDA adjustments many firms use to mask true debt levels.
“The documents today do not provide at all the comfort the senior lender could have pre-crisis,” he said.
To make matters worse, ratings factors of CLOs themselves are deteriorating, he said.
Some of Tavangar’s sentiments were shared by others on the panel at Information Management Network's annual CLO conference in New York. Chris Padgett, senior vice president and head of leveraged finance research at Moody's Investors Service, questioned whether some of the highest-leveraged, lowest-rated firms taking out syndicated bank loans today would have an “inability” to repay debt in the event of a downturn in the credit cycle.
“When it comes to refinancing, will they be able to do that?” she asked rhetorically.
The doubts raised at the panel stood in contrast to opening remarks made by keynote speaker Stephen Moore, an unabashed champion of what he calls “Trumponomics” (the name of his forthcoming book co-written with Art Laffer).
In a half-hour address to an audience he identified as evenly split between pro- and anti-Trump, Moore asserted that the tax cuts and deregulation agenda pushed by the current administration will fuel 3% annual economic growth and reduce federal government deficit levels (as a percentage of GDP) for decades to come.
“I’m so bullish on the U.S. economy right now,” said the cable-news pundit and distinguished visiting fellow from the Heritage Foundation, a conservative think tank.
The panel, for the most part, was also optimistic on near-term performance of the CLO and leveraged-loan markets. Padgett, for instance, noted that the market for loans is liquid, thanks to high demand from institutional and retail mutual fund investors. She credited this in part, to the nearly negligible 1.6% corporate default forecast for next spring.
Peter Acciavatti, a managing director who heads fixed-income, high-yield strategy for JPMorgan, said the bank expects continued “fairly robust” issuance of CLOs and leveraged loans for the next two years, driven mainly by seven expected Federal Reserve interest rate hikes that will make floating-rate assets attractive.
Through May 22, new issuance of CLOs had reached $15.4 billion, putting it on pace to break the record monthly level of $16.3 billion set in April. Acciavatti noted, however, that demand for CLOs is balanced by the rise in available loan collateral. CLOs hold around 50% of the outstanding $1 trillion loans, whereas in the more heated pre-crisis era they gobbled up around 60% of the market.
Another positive, according to panelists, is the fact that today’s CLOs hold fewer loans financing mergers and acquisitions than they did a decade ago. Nevertheless, Padgett noted that recovery rates on loans that do default are declining.
Which is why, Tavangar said, “We’re far more focused on the brush fires.”
“Clearly today we’re seeing a situation where capital structures are highly leveraged, and that requires perfect execution of a business model,” he said. “There is always a notion of [being] overleveraged. It is a question to ask, very seriously, even if you’re considering a growth environment in the 3s" in percentage terms.
