Debt Flagged by Fed Bought by Funds Copying 2007: Credit MarketsLisa Abramowicz and Sridhar Natarajan
Money managers from Ares Management LLC to Onex Corp. are borrowing at the fastest pace in six years to buy the type of speculative-grade loans that federal bank regulators warned last week is becoming riskier.
Ares, which oversees $59 billion, and Onex’s credit unit are among firms that have raised $22.9 billion of collateralized-loan obligations this quarter, approaching the all-time high of $26.4 billion in the three months ended June 30, 2007, according to Royal Bank of Scotland Group Plc. Leveraged-loan mutual funds have received their two biggest weekly inflows since January.
At the same time the Federal Reserve’s zero interest-rate policy is encouraging investors to seek ever-riskier debt assets to generate returns, some members of the central bank are also saying the market may be overheating. The Fed is now seeking to curb risk by updating guidance on best-underwriting practices for loans.
“What the Fed is trying to say is, ‘We know that demand is there, we’ve created that demand, but we don’t want you to take advantage of that demand to hurt us in the future,’” said Matthew Duch, an investment manager who helps oversee $12 billion in assets at Bethesda, Maryland-based Calvert Investments Inc. “The leverage in the system, while it may be OK now, unwinding it when money starts to flow to other places may be the problem.”
Ares, based in Los Angeles, is also planning a closed-end fund that will use borrowed money to buy mostly high-yield loans and bonds, according to a March 20 regulatory filing, as federal banking agencies say the quality of the debt is deteriorating. The $4.5 billion that was raised for closed-end credit funds this year through March 5 was the most for the period since 2007, according to Miami-based Thomas J. Herzfeld Advisors Inc.
CLO issuance soared to $7.4 billion this month, $900 million more than February, helping this year’s sales surpass the $22.6 billion sold in the fourth quarter, according to RBS strategists Richard Hill and Ken Kroszner.
“This is the kind of thing that happened before the crisis, when the market was artificially inflated because of the leveraged buyer in the space,” Frank Ossino, a Hartford, Connecticut-based money manager who oversees $2 billion of leveraged loans at Newfleet Asset Management, said in a telephone interview. “We are approaching that excess and that’s the kind of thing we need to watch.”
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. rose. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbed 0.1 basis point to a mid-price of 90.5 basis points as of 11:21 a.m. in New York, according to prices compiled by Bloomberg.
The index typically rises as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.17 basis point to 17.31 basis points as of 11:22 a.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.
Bonds of General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5.3 percent of the volume of dealer trades of $1 million or more as of 11:27 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. GE Capital Corp. may issue fixed- and floating-rate bonds as soon as today, according to a person familiar with the transaction.
The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index rose 0.07 cent last week to 98.23 cents on the dollar, reaching the highest level since July 22, 2007, and up from 96.09 at year-end. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 1.97 percent this year.
Leveraged loans and high-yield, high-risk, or junk, bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.
Banks that have shepherded $217 billion of dollar-denominated leveraged loans this year into the market need to orchestrate the financing in a “safe and sound manner” as non-regulated investors are willing to accept looser terms and “prudent underwriting practices have deteriorated,” according to a March 21 notice from federal bank regulators.
While banks are responsible for educating investors about deal terms, the burden is on buyers to determine the risk involved, said A.J. Murphy, co-head of global leveraged finance at Bank of America. The firm is the largest underwriter of leveraged loans in the U.S., Bloomberg data show.
“We understand the tension and pressure that drives investors to take more risk,” she said in a telephone interview. “Ultimately, the institutional investor makes the decision in terms on how much risk to bear and where it prices.”
Four years after the Fed began holding benchmark borrowing costs between zero and 0.25 percent to rescue the world’s biggest economy from the credit crisis, concern is mounting that debt yields at about record lows aren’t compensating investors for their risk.
Investors are accelerating flows into funds that focus on leveraged loans, which are ranked higher than corporate bonds in a borrower’s capital structure in case of a bankruptcy and are better protected from rising interest rates because they typically are pegged to floating-rate benchmarks. The value of a fixed-rate security diminishes with an increase in rates.
U.S. loan funds reported $1.4 billion of deposits last week, the second-most behind the $1.5 billion received in the second week of February, according to Bank of America Corp.
Onex, Canada’s largest publicly listed buyout firm, is expanding its efforts to issue CLOs, selling at least $512.1 million of the debt this month, Bloomberg data show. CLOs are a type of collateralized debt obligation that issue securities of varying risk and return and use the proceeds to buy pools of high-yield, high-risk loans.
“We’re very keen to continue growing that business,” Seth Mersky, a senior managing director at Toronto-based Onex, said in a phone interview on March 13. “It will be an important source of assets under management and fees.”
The Ares Multi-Strategy Credit Fund would invest at least 60 percent of its assets in speculative-grade loans and bonds and as much as 40 percent in CLOs and other asset-backed securities, and would incur leverage equal to about 33 percent of managed assets, according to the March 20 filing.
Yields on junk bonds globally dropped to a record low 6.3 percent on March 15, Bank of America Merrill Lynch index data show, even as the strength of covenants governing the notes fell to the lowest in at least two years as measured by Moody’s.
The average covenant score for speculative-grade bonds, in which 1 is the strongest and 5 is the weakest, was 3.96 in February, the lowest since the ratings company began tracking the data in January 2011, Moody’s said March 12.
Companies in the U.S. obtained more than $31 billion of covenant-light loans in February, compared with the previous peak of $23.4 billion in April 2007, Bloomberg data show. The loans have fewer safeguards such as limits on how much debt a company can add to its balance sheet.
Fed Governor Jeremy Stein has warned that some credit markets, such as corporate debt, are showing signs of potentially excessive risk-taking. In a speech in St. Louis on Feb. 7, Stein cited leveraged loans and junk bonds as areas that have been “very robust of late.”
Esther George, president of the Federal Reserve Bank of Kansas City, spoke about the elevated price of assets such as high-yield and leveraged loans in a speech Jan. 10.
The central bank’s latest lending guidance puts investors on notice, Newfleet’s Ossino said.
“This is the Fed’s way of telling us that you are putting your beer goggles back on,” he said, referring to the alcohol-induced state in which appearances are improved. “The Fed is saying you guys need to wake up.”