The Unseen Risk in the Booming Loan Market
Low yields led investors to dive into loans but there are signs that the generalists are stepping away.
By Paul J. Davies
Central bank money inflated the markets for risky loans and the investment vehicles that buy many of them. Now, there are early signs of that driving force going into reverse.
In recent weeks, a growing share of new borrowers have had to lift interest rates on leveraged loans to win over investors. This might just be a touch of indigestion after several large deals to fund private-equity buyouts and takeovers, but some bankers think it is an early signal that liquidity is retreating from low-quality debt.
The trouble for borrowers isn’t rising debt costs today, but the risk that loans will be harder to refinance in future when investor money washes back to safer assets as yields improve. This matters because more than 40% of leveraged loans are typically used to refinance an existing loan. In the financial crisis, even some relatively healthy companies couldn’t refinance and had to reach deals with existing lenders to extend their debt.
Loans are popular right now because their yields adjust with interest rates, so they don’t lose money like fixed-rate bonds do during times of rising rates. The real problem lies in how investors who don’t normally buy loans will react to the end of quantitative easing, or central bank bond buying programs, which pushed them into risky loans in the first place.
As these programs unwind, more traditional fixed-income assets, such as government bonds and high-grade corporate debt, offer better yields. As bond yields recover to more normal levels and rate rises slow, investors won’t need to take risks on credit or complexity.
Higher rates will also likely weaken borrowers’ equity valuations and make debt a bigger chunk of their enterprise value. The same loan will thus look riskier, plus there will be less funding available if investors who typically buy bonds leave the loan market. That is when refinancing risk jumps.
The pushback on loan pricing began in spring, but has become more prevalent. One of the first big deals to suffer this year, according to bankers, was the $2.3 billion loan that is helping fund McDermott International’s takeover of rival engineer CB&I. Bankers had to lift the spread by 0.75 percentage points to 5% before investors would bite in April.
More recently, a string of loans have had to increase spreads by an average of 0.5 percentage points, according to data from S&P Global Market Intelligence’s LCD research service. In all, about 30% of new loans had to increase spreads during marketing in June and the first half of July—up from 12% in May.
This happened because fewer investors who don’t typically buy loans were bidding, according to bankers. Something similar also happened to new issues of collateralized loan obligations, the debt-funded vehicles that buy more than half of all new loans.
Loan pricing may have moved, but other terms remain very aggressive, by some measures more so than in 2007. Debt multiples on private-equity deals are as high as then at more than six times earnings on average, but investors complain that these earnings are often flattered by things like assumptions on cost savings. Also, the covenants that protect lenders by allowing them to act when things deteriorate have all but disappeared. They mostly still existed in 2007.
Worse quality loans means lenders will get less money back when defaults pick up. But even without defaults, the worry is that there won’t be enough lenders to cover borrowers’ refinancing needs in years ahead.
This could leave lenders little choice but to extend the life of loans on whatever terms borrowers can afford. Be careful what loans you buy now—you may end up stuck with them.
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