“What I’ve always worried about is that the existence of overleveraged corporations will exacerbate a downturn that occurs for any reason,” said former Fed Chairwoman Janet Yellen in an interview.
Years of low interest rates and easy credit have allowed companies across the board to borrow big, building a record $10 trillion mountain of debt. Lenders expect the vast majority of that money to be repaid on time.
The epicenter of risk involves a subset of that total: $1.2 trillion in leveraged loans, junk-rated debt secured by corporate assets much like mortgages are backed by homes. The market has exploded, ballooning by almost 50%—or $400 billion—since the start of 2015, as investors desperate for the high interest payments these loans provided threw cash at borrowers.
Private-equity firms fueled a lot of the growth, borrowing billions at a time to buy brand names including Dell Technologies and Staples Inc. Smaller but relatively stable public companies like car supplier American Axle & Manufacturing Holdings and electrical supply maker Atkore International Group Inc. also took out leveraged loans to fund share buybacks and acquisitions.
The banks that make such loans rarely hold on to them now because of regulations passed after 2008. Instead they sell the debt directly to money managers or repackage it into complex securities that are marketed to investors around the world.
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When prices of the loans drop, or they fall into default, the losses hit pensions, insurers, and scores of mutual funds and hedge funds, some of which react by selling out, exacerbating market swings.
In addition, investors become less willing to buy new loans and the banks that arrange such deals stop making new ones. That can be compounded by sharp losses in the complex securities Wall Street repackaged many of the loans into, causing credit markets to seize up and leave already indebted companies without access to fresh cash. The consequences could cascade: A wave of defaults and bankruptcies, forcing job cuts and amplifying the economic slowdown.
The impact will likely be long and drawn-out. Most loans don’t start coming due until 2022 and the hardest-hit sector—energy—is a small component of the market. Still, loan prices can fall sharply well before companies run out of cash, hurting investors who own the debt. And as business dries up for some companies, they may not be able to stay current on their existing loans.
Leveraged loans suffered their worst run since the financial crisis this month when a widely tracked index lost about 16% of its value. Prices for loans to 24 Hour Fitness Worldwide, which operates a chain of gyms, fell to about 44 cents on the dollar this week from 80 cents in February, according to analytics firm AdvantageData Inc. Prices of loans to airlines such as United Airlines Holdings Inc. and American Airlines Group Inc. declined about 10% in the first two weeks of March, more than any full-month loss since October 2008, according to S&P Dow Jones Indices.
Repackaging loans into bundles called “collateralized loan obligations” became popular in the 2000s, alongside similar techniques employed to market mortgage-backed bonds. Unlike mortgage bonds, very few CLOs defaulted in the 2008 financial crisis. That record and their high yields have made CLOs popular in recent years, but they are susceptible to violent price swings and have been one of the worst-performing debt investments this month.
Loan investors remain hopeful that the virus will subside and that its aftershocks will be brief. But with the amount of loans outstanding about twice as large as in 2008, according to data from S&P Global, a recession will likely trigger a larger wave of defaults and heavier losses on their debt than the dot-com bubble or the financial crisis, analysts say.
Companies that borrow in the junk loan market now are far weaker financially than those in that era. Borrowers with loans Moody’s Investors Service rated at the lowest rungs of the junk-debt ladder—B3 or lower—made up 38% of the market in July compared with 22% in 2008.
“Investors will probably be surprised by the extent of their losses on loans compared with their historical losses,” said Oleg Melentyev, a strategist at Bank of America Corp. He calculates that about 29% of outstanding leveraged loans will likely default cumulatively in the next credit downturn, compared with an average of about 20% by junk-rated companies during the 2007 to 2009 period. Worse yet, investors will likely recover less money: about half of their original investment, compared with 58% back then.
The storm is rocking even well-established leveraged-loan borrowers like hotel chain Hilton Worldwide Holdings Inc. The company took out a $2.6 billion loan in June to refinance debt left over from when Blackstone Group bought it over a decade ago, according to data from LevFin Insights.
Prices for the loan, stable at 100 cents on the dollar in late February, have now fallen to about 83 cents on the dollar, according to data from IHS Markit. The company has borrowed more in recent days on a $1.75 billion revolving loan—basically a line of credit—to build cash as tourism and travel plummet. Prices of the revolver have fallen to around 79 cents.
Other companies won’t have the same access to cash. “The real risk is in those incremental borrowers, the borrowers who need access to capital that could dry up,” said Frank Ossino, senior loan portfolio manager at Newfleet Asset Management, which holds about $2 billion of leveraged loans in the $10 billion of investments it manages.
Cracks appeared in the market last week as businesses sent workers home, travel slowed, sports leagues halted play and predictions about the virus’s economic impact grew increasingly dire.
Moody’s downgraded Cirque du Soleil Inc. on Wednesday to a credit rating “in, or very near, default” after the company, which employs 4,000 people, suspended its shows in Las Vegas. Prices of about $700 million in loans the circus operator mostly borrowed for its purchase by private-equity firms in 2015 fell to 68 cents on the dollar from around 94 at the start of the month, according to data from IHS Markit. Officials for the company couldn’t immediately be reached for comment.
CLOs are highly susceptible because they use borrowed money to buy leveraged loans, boosting the yield, and the risk, of the investments. CLO managers issue bonds to buy bundles of leveraged loans, then use cash flow from the loans to pay interest and principal on the CLO bonds, pocketing the difference.
When downgrades and defaults mount, CLO managers stop making payments on their most junior bonds, prices plummet and the market for new CLOs shuts down. Lower-quality CLO securities were the worst performers this month out of 29 types of debt measured by Citigroup Inc. analysts, losing 22% through March 13.
“CLO formation has come to a grinding halt,” said Alex Jackson, chief investment officer for Nassau Corporate Credit, which manages six CLOs and had planned to launch more this year. “It does feel like the market accelerated into a panic over the course of the week.”
Pain TradeLeveraged loan prices are plummeting,punishing investors who piled into the debt inrecent yearsS&P Global Leveraged Loan IndexSource: S&P Dow Jones IndicesNote: Data as of March 18
Loan markets seized up briefly the last time stocks tumbled in December 2018, but the declines are much sharper now and many fear a more prolonged disruption. During the last financial crisis, issuance of new leveraged loans slowed to a trickle for about a year starting in August 2008, according to data from S&P Global Market Intelligence.
Also worrying, it became increasingly difficult last week to trade existing loans of large companies normally viewed as comparatively safe bets. The gap between what sellers were asking and what buyers wanted to pay for Dell loans widened to 2 percentage points last week from about a half-point normally. On March 9, too few banks were making markets in the $5.3 billion loan of fast-food chain Restaurant Brands International, which owns Burger King, to accurately price the debt, according to IHS Markit.
If trading dries up, investors and analysts hope the Fed can intervene to avoid a credit crunch. The central bank on Sunday slashed interest rates to near zero and said it would buy $700 billion in Treasurys and mortgage-backed securities to help ease stress in the financial markets.
On Tuesday, the Fed announced plans to start making loans to American companies in a bid to unclog the $1.1 trillion market for short-term IOUs called commercial paper, which companies use to finance day-to-day business operations such as payroll expense.
Eric Rosengren, president of the Federal Reserve Bank of Boston, said earlier this month that without a stronger response from Congress and the White House to combat any downturn, the Fed would need Congress to authorize new tools to spur growth, such as allowing the central bank to purchase corporate bonds and other private-sector assets.
A high level of corporate debt “is one of the negative outcomes of having low interest rates for a long time,” he said. “We’ll see how much of a problem that is for unemployment.”
Worries over the risk in the leveraged loan market have been overstated, said Lee Shaiman, head of the Loan Syndications and Trading Association trade group. The biggest industries in the market, like business services and technology, are less affected by the virus than others, he said. And lower interest rates have cut debt expenses for most borrowers significantly in the past month. Energy companies, among the worst hit in the March turmoil, comprise only 3% of the loan market, according to data from S&P Dow Jones Indices.
But low-rated companies also borrowed more against their assets than ever before, while granting fewer lender protections, or covenants. And there are signs of weakness in some technology firms, which make up about 15% of the loan market. Loans of Coral Gables, Fla.-based data center operator Cyxtera Technologies fell about 14% this month to 72 cents on the dollar, according to IHS Markit.
Some losses will hit investors in mutual funds, which now own about 10% of outstanding leveraged loans, down from around 17% in 2018 at the recent peak of the market’s popularity, according to research by Barclays PLC. About 65% of the loans are now owned by CLOs.
Some CLO managers who are struggling to sell bonds to investors have begun liquidating the loans they had been accumulating in warehouses, fund managers said. Loans in such warehouses amounted to $10 to $12 billion in early March, according to research by Wells Fargo Securities.
New York Times’ bestselling author, former M&A investment banker, and long-time financial journalist, William Cohan, joins Ed Harrison to discuss the perilous state of U.S. credit markets, quantitative easing, junk bonds, and the ever-expanding pool of global debt. Predicated on the idea that persistently low interest rates have fueled distortions in the pricing of risk, Cohan argues that Wall Street has been developing a dangerous dependency that won’t end profitably for the majority of investors. Filmed on January 7, 2020, in New York.