Why Investors Need Caution in $1 Trillion Loan Market
The market for risky loans often used in buyouts has ballooned on investor demand
By Paul J. Davies
LEVER UP
Total volumes outstanding in U.S. risky loans and bonds*
Sources: ICE; S&P Global LCD
Note: As captured in ICE BofAML High Yield Index and S&P/LSTA Leveraged Loan Index
Demand for risky loans that fund private-equity buyouts and other highly indebted companies has pushed the size of the market beyond $1 trillion for the first time. Investors should be aware that rising interest rates will make life harder for borrowers.
Individual investors are pouring cash into mutual funds and exchange-traded funds that invest in leveraged loans because their income rises as interest rates go up. Bonds in contrast lose value as rates rise. Leveraged-loan funds have had nearly $5 billion of net inflows so far in 2018, according to Lipper. However, rising income for investors only works up to a point: higher rates eventually squeeze borrowers.
The loan market has nearly doubled in size since mid-2012, according to S&P Global’s LCD research arm, and is expected to keep growing strongly as private-equity firms hunt for ways to invest record amounts of funds raised in the past couple of years.
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Loans due to come to market soon include a big chunk of the $13.5 billion financing Blackstone needs to back the spinoff of Thomson Reuters’ information business.
The market has almost caught up with that for junk bonds, which has shrunk to $1.25 trillion from a peak of $1.4 trillion in the past couple of years. Junk-bond funds have suffered around $10 billion of net outflows in 2018, according to Lipper.
Borrowers like loans because they can be repaid or refinanced at any time and are cheaper: the yield on the S&P/LSTA U.S. loan index is 5.6% compared with 6.5% on the ICE BofAML U.S. high-yield index.
At the same time, covenants on loans—which historically allowed lenders to step in if a company started to get into difficulties—have been disappearing as investors became less discerning. The upshot is risky companies have refinanced maturing bonds with loans, leading to a shrinking junk market.
For investors, loans’ big attraction is protection against rising U.S. interest rates because loans pay a floating rate tied to an underlying market interest rate, known as Libor. High-yield bonds, in contrast, pay a fixed coupon, so lose value as rates rise.
However, rising rates will bite eventually. Right now, companies with leveraged loans have plenty of earnings before interest, tax, depreciation and amortization relative to their interest costs. According to UBS , this interest cover is more than three times. But borrowers can only withstand three more rate rises before interest costs start to become more painful—and UBS expects six increases by 2019.
The market is also riskier than it was in 2007, according to LCD. While the cost of loans is in a similar range, more than half of borrowers now are rated single-B+ or lower: In 2007, less than one-third of the market was that poorly rated.
The message for investors: a lot more caution will be needed as the year goes on.
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