With credit woes cutting a broad swath through the stock and bond markets—and given the scrutiny that's been paid to the role leverage played in the financial crisis—it's understandable that investors should be shunning any asset class carrying even a scrap of risk. When it comes to leveraged loans, the secured bank debt that private equity heaped on companies in order to acquire them through leveraged buyouts, the deep aversion makes even more sense. The reason? Experts believe many of these companies will default on their debt as a result of the recession.
But risk is a two-sided coin in finance. Fund managers who invest in leveraged loans say the current distressed market prices offer a once-in-a-lifetime opportunity to own assets that will deliver huge returns over the long run. A word of caution, though: The mutual funds making these bets are more suitable for people with a long-term time horizon for their portfolio, not those looking for some quick asset allocation fix, says Bill Larkin, portfolio manager for fixed income at Cabot Money Management in Salem, Mass.
The primary draw of leveraged loans for the pros: When a company defaults on its debt, holders of bank loans, which have certain of the borrowers' assets and/or stock pledged as collateral, are higher up in the capital structure and generally get paid before holders of unsecured debt and equity holders. And these loans can be bought at sharply discounted prices, around 65 cents on the dollar on average, say fund managers.
The discounts have little to do with questions of fundamental value and more to do with the sheer volume of selling by hedge funds and other owners who need to raise cash quickly to meet margin calls and a heavy volume of redemption requests by holders of their funds. With funds looking to dump the loans en masse, most leveraged-loan investors are laying back, wary of being burned if the market still has a way to go before reaching bottom.
This is the first time in the history of the asset class that leveraged loans offer potential for equity–like returns, said Tom Ewald, chief investment officer for bank loans at Invesco AIM Worldwide Fixed Income, on Invesco AIM's Web site.
Still, the credit freeze and mounting worries about corporate debt defaults likely to result from what's projected to be the worst recession in 26 years have dealt a body blow to the performance of mutual funds that specialize in bank loans. Mutual funds—and closed-end funds, which trade like equities—are the most logical way for retail investors to participate in leveraged loans.
These funds' returns are down 18% to 32.3% year-to-date as of Dec. 10. The losses at closed-end funds are much higher, around 50% year-to-date, due more to worries about the 25% leverage positions those funds hold and their ability to maintain high monthly dividend payments than concerns about the actual asset class.
The credit quality of the loans in the Eaton Vance Floating-Rate Fund-Advisors Shares (EABLX) "has ebbed and flowed within a narrow margin pretty much forever," says Scott Page, co-manager of the $2.51 billion portfolio. "One thing that's different this time is the companies are larger because private equity firms were buying larger companies" and getting larger loans to finance them during the recent leveraged buyout boom.
That's the main reason for the dramatic drop in prices for bank loans, which are down 20% to 25% in the last 120 days, loss rates not seen in 25 years, he says. "It is not reality-based in terms of what I focus on," which is mostly companies' ability to repay their debt and, if they can't, what the reasonable chances are of the fund recouping most of its investment.
"If 100% of the companies in our portfolio went bankrupt tomorrow, our historic recovery would be 70%, which is above where they're currently trading," about 65¢ on the dollar, he says. There's nothing about the companies in his portfolio that warrants their trading 25% down from where they were last summer, he adds.
For companies that use leveraged loans and have a debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio of four times, it's not uncommon in the current environment for those loans to trade at 65¢ on the dollar, says Bryan Krug, a portfolio manager at Waddell & Reed who oversees the $150 million Ivy High Income Fund (WRHIX), just under 15% of which is comprised of bank loans. Marking such a company's loans to the current market valuation would result in an absurdly low ratio of 2.6 times EBITDA, he points out. "I can't think of too many businesses valued at as little as 2.6 times EBITDA," Krug says.
The spread on the Markit LCDX index, which is comprised of 100 loan credit default swaps—insurance contracts against first-lien bank loans—closed at 1,840 basis points on Dec. 10, up from about 550 basis points in mid-October. That indicates that the annual cost of protection against defaults on secured bank loans has more than tripled over the past two months.
The real question investors have is how much money will come into this asset class to absorb the excess supply, says Krug at Waddell & Reed. "Once you get all this stuff sopped up and in the right hands, it should have a significant rally," which he believes won't be more than three months away, he says.
"The investment banks don't have a lot of inventory [of leveraged loans or high-yield bonds] on their balance sheet, and once the sellers of the asset class, primarily hedge funds, are done disposing of the assets, I would expect to see a significant rally," he adds.
In his own fund, Krug remains underweight in financials and even more underweight in the automotive sector. But overall, he says he sees a lot of opportunity, for both bank loans and high-yield bonds, in so many different industries, that it's not necessary to reach for yield in certain risky areas in order to get a good return.
Cabot Money Management's Larkin advises investors to stay away from closed-end funds, which, in addition to bank loans, are holding leverage in the form of auction-rate securities that they can't get rid of and will need to refinance at higher interest rates. He recommends investors confine themselves to open-end funds whose yields aren't nearly as compelling without the leverage component that closed-end funds have. But he says it's too early for investors with less appetite for risk to use open-end funds as an asset allocation tool, since the recovery rates will probably drop.
The ratings agencies are projecting a default rate of at least 10% for bank loans, and Page at Eaton Vance says he expects to see defaults approach 10%.
Krug says it wouldn't surprise him to see loans default at a rate of 8% to 10% in 2009. If you assume a recovery of 70¢ on the dollar for loans that default, that would translate to a loss of 30% on 9% of one's fund, or a total loss of 2.7%, he says. While Krug doesn't downplay the severity of the economic downturn, he believes the leveraged loan market is fully discounting those problems.
One indication of the high level of risk involved in leveraged-loan investments: the growing possibility that a number of firms that go bankrupt will be liquidated instead of reorganized.
Hedge funds, which now hold more secured loans than banks, have less incentive to see a company whose debt they hold restructured, and are more likely to push a company that defaults on its debt into liquidation, says Martin Fridson, chief executive of New York-based Fridson Investment Advisors. Those odds are even greater if hedge funds have shorted the subordinated debt and stand to make more money from a liquidation. Liquidations require the approval of all classes of shareholders and creditors, however, and unsecured bond holders could vote to block it, he adds.
Page at Eaton Vance doesn't accept that there will probably be a greater number of liquidations because of hedge funds holding secured bank loans, and says that liquidation "is not the best economic outcome for anybody, including hedge funds."
But Standard & Poor's said in an Oct. 23 report that "liquidation is becoming more likely in default and recovery scenarios, with market conditions making the financing needed for companies to emerge from bankruptcy as going concerns increasingly scarce." S&P drew special attention to constraints on debtor-in-possession, or DIP, loans, which typically are used to pay vendors and cover a company's ongoing operating costs.
The allure of bank loans will be substantial once the economy has healed and the bankruptcy threat has shrunk, but you need to be ready for a rocky road in the meantime, and that could be longer than some people think.