SHORTING LOANS: A HEDGE AGAINST FINANCIAL TROUBLE / THE WALL STREET JOURNAL

Shorting Loans: A Hedge Against Financial Trouble

It won’t take much for investors in booming loan funds to wake up to the growing risks

By Paul J. Davies


The growing risks in low-quality loans are starting to attract attention from market watchers. Photo: bryan r. smith/Agence France-Presse/Getty Images


Riskier corporate debt may face a very bumpy ride this year.

One way to play this is to bet against an exchange-traded fund that buys U.S. leveraged loans, the risky debt behind takeovers and private-equity deals. The biggest of these is the Invesco Senior Loan ETF . BKLN -0.07%▲

The loan market has been flooded with inexpert money, which has worsened lending standards even compared with the debt bubble that ended in the 2008 banking crisis. There is plenty to spook investors and loans are still a relatively illiquid market, so a little selling pressure can cause a lot of trouble.

The growing risks in low-quality loans are already starting to attract attention. Excluding income from interest, Invesco’s loan ETF has slid about 1% since late January, its high point in 2018. The next largest loan ETF, run by Blackstone GSO, is off by a similar amount.

So far, the declines have been more than offset by the income generated by the loans, but the declines could now accelerate. Three risks in particular probably aren’t appreciated enough by nonspecialist investors.

First, rising interest rates are great for investors in floating-rate loans—until they aren’t, to paraphrase a UBS analyst. There comes a point when higher interest payments start eating up too much of a company’s cash Flow.

U.S. rate increases have already pushed up total interest costs for loans by a percentage point to about 5.7% since the final three months of last year, according to UBS. And higher funding costs haven’t been matched by earnings growth for more lowly rated borrowers.

Second, there are more lowly rated borrowers than ever: Today almost two-thirds of leveraged loan issuers are rated B2 or lower by Moody’s, or single-B in other agencies’ scales. That compares with less than half in 2006.

Third, a growing share of borrowers reports leverage multiples based on adjusted earnings numbers; in other words, they add back dollars for one-time costs or for savings the owners plan to achieve.

Together these problems suggest losses will be greater when borrowers default than in previous cycles. But investors won’t wait for widespread losses before reducing their exposure. When junk-rated energy companies hit trouble in late 2015, all high-yield credit sold off. At that time, Invesco’s loan ETF dropped more than 7% between September 2015 and February 2016.

Now, the profits of some U.S. sectors are likely to be hurt by the escalating trade war, which could hurt the whole high-yield market again. The end of ultraloose monetary policy and rising yields on safer assets will also make risky credit less attractive to investors.

Whatever the trigger, it won’t take much to spark trouble for leveraged loans.