Debt-laden U.S. firms have been shunning the so-called leveraged loan market lately, as this segment of the market has been scrutinized and the prospect is that the Federal Reserve will make its first rate cut in more than a year this week Decade.
The roughly $ 1.2 trillion leveraged loan sector, once a glowing area of the debt market, has cooled significantly. The sector has seen a number of setbacks, including investors rejecting easy credit conditions and dwindling supply of new credit.
The withdrawal, however, may be music to the ears of regulators, analysts, lawmakers, and others who have pointed to record loan volumes from heavily indebted companies as evidence of an emerging financial crisis.
Leveraged Loans – typically used in private equity buyouts by companies that are already heavily burdened with debt, are the preferred route for companies due to looser repayment schedules and more borrower-friendly terms.
However, companies have turned to other areas of the bond market for funding, including the high-yield or junk bond market, and are avoiding leveraged loans.
At least part of the waning interest in leveraged loans can be attributed to the fact that the US Federal Reserve will cut federal fund key interest rates by at least 25 basis points on Wednesday in a range of 2.25% -2.50%. Lower Fed Funds rates can depress leveraged loan investments as the leveraged loan rates are linked to the Fed Funds-sensitive Libor, the London Interbank Offered Rate.
“Leveraged loan mutual funds saw significant cash outflows when it became clear that interest rates are unlikely to go up or down,” said Christina Padgett, senior vice president, Moody’s Investors Service.
Including last week, loan funds have seen combined outflows of $ 43 billion since the beginning of the fourth quarter, or approximately 28% of their assets under management and all of their inflows over the past two years, according to analysts at JP Morgan.
But the outflows have also occurred at a time when new credit was not created. This JP Morgan chart shows gross leveraged loan supply declining 65% this year, with volume a fraction of last year’s $ 510.6 billion.
Meanwhile, the supply of high-yield bonds this year has already exceeded expectations. Goldman Sachs said Friday that it raised its forecast for high-yield US bond issuance for the year to $ 185 billion. The bank’s earlier forecast was 12% lower, but buoyant activity since January has “surprised the upside,” analysts said in a statement to clients. Compared to leveraged loans, high-yield bonds tend to have fixed coupons, which are usually calculated on the basis of the Libor plus a fixed premium on this rate.
Goldman said leveraged lending fund outflows were one of the main catalysts behind the changing financing pattern.
“With leveraged loan funds’ low tech specs under pressure since late 2018, we believe HY-rated borrowers have increasingly used the HY bond market for their funding needs,” wrote Goldman analysts.
In fact, the junk bond market has $ 142.2 billion since the start of the year.
US junk bonds tend to closely track the performance of US stocks, including both the S&P 500 SPX,
and Nasdaq Composite Indices COMP,
Set all-time highs.
Read: Stocks hit new intraday record highs on Friday
The global hunt for yield has been a driving force in US junk bonds this year. Currently, a quarter of global bonds offer negative returns, meaning investors get less back than their initial investment.
cash: 25% of the world’s bonds make lenders pay for the privilege of owning them, as the graph shows
Demand for high-yield bonds pushed spreads down to 4.51 percentage points versus US Treasuries on Friday, or 21.9% below the 12-month high, according to JP Morgan data.
A bond spread is the amount of compensation an investor would ask against a risk-free benchmark, making it an important metric for investor sentiment.
“The spreads were pretty tight compared to their previous level,” said Lale Topcuoglu, Senior Fund Manager at JO Hambro Capital Management, in an interview. “If you can get a ten-year bond at those rates, you should do that all day.”
In comparatively higher quality corners of the junk category, lending rates ranged from a high 4% to a low 5%, she added.
Concerns about leveraged lending have been raised by a number of past and current regulators and industry experts, compounded by the implosions of some companies tied to leveraged loans.
Last week, Senator Elizabeth Warren issued a new warning on leveraged loans, saying that if nothing is done to curb borrowing, they will play a role in the coming US economic crash. Sheila Bair, former head of Federal Deposit Insurance Corp., told MarketWatch last month that a leveraged lending bankruptcy could quickly hit the economy.
Read: Senator Elizabeth Warren Says “Warning Lights Are Flashing” Warning That “The Chances of Another Economic Downturn Are High”
Negative attention in leveraged lending has encouraged investors to push back business conditions that they consider too risky.
Last week, LPC / Reuters reported that credit investors have rejected the terms of a proposed buyout loan of up to $ 1.1 billion to Irish software company ION Group for the acquisition of financial media and data company Acuris.
Instead, the funding was completed through a private debt placement, according to the report.
Still, today’s lower interest rates are the biggest factor driving borrowers’ behavior, Topcuoglu said.
“The concerns about leveraged loans haven’t really changed,” she told MarketWatch. “It’s been the same story for about 12 to 18 months.”
Read: This is why the Fed and global regulators are sounding the alarm about leveraged loans and CLOs
“In this environment, it might make more sense to use high-yield bonds when demand has been strong and the market is still looking for yield,” said Moody’s Padgett.