Junk Loans Top ’08 Record as Safeguards Stripped: Credit MarketsSridhar Natarajan and Krista Giovacco
The amount of loans to the riskiest U.S. companies ballooned to a record this year, propelled by unprecedented demand for floating-rate debt that offers protection from rising interest rates.
The market for junk-rated loans increased to $683 billion, exceeding the 2008 peak of $596 billion, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data. The $130 billion surge this year was fueled by borrowings that don’t include typical lender protections such as limits on leverage.
Loans, which suffered the biggest losses in the fixed-income market during the financial crisis, staged a comeback as investors funneled a record $64.4 billion into funds that buy the debt in anticipation the Federal Reserve would start unwinding its bond buying that’s suppressed borrowing costs. The demand has enabled companies take on more debt for shareholder rewards, prompting regulators to warn that the excesses which contributed to the credit crisis may be creeping back.
“The worst deals are made in the best of times is a phrase we hear often,” Frank Ossino, a money manager in Hartford, Connecticut, who oversees $2.5 billion of loans at Newfleet Asset Management LLC, said in a telephone interview. “While the default environment will remain low, ever more aggressive transactions become the seeds of the next default cycle.”
Companies from personal-computer maker Dell Inc. to Hilton Worldwide Holdings Inc., the world’s biggest hotel chain, obtained $282 billion of loans that were covenant-light, meaning they didn’t include financial maintenance requirements, according to data compiled by Bloomberg.
Speculative-grade companies also stepped up borrowings to pay their owners dividends, with issuance of such debt reaching a record $63 billion this year, Bloomberg data show. Dividend deals, rather than refinancing debt at lower interest rates or funding expansion, do little more than add leverage.
These risky borrowings have been supported by record flows into loan funds, whose assets grew by 85 percent in 2013, according to a Dec. 19 report from Bank of America Corp.
While increasing investments into loan funds enhances liquidity and increases transparency, the ability of individuals to withdraw money on a daily basis increases the risks of deeper selloffs because “there’s less sticky money in the system,” Ossino said.
In 2008, when the global economy was in the throes of the biggest financial crisis since the Great Depression, loans in the U.S. tumbled 21 percent in the fourth quarter of 2008, compared with a drop of 18 percent for junk-rated bonds, according to the S&P/LSTA Leveraged Loan Total Returns Index and the Bank of America Merrill Lynch U.S. High Yield Index. Investment-grade debt gained 1.6 percent.
The growth in junk loans has led regulators to warn about deteriorating underwriting practices.
The Fed and the Office of the Comptroller of the Currency sent letters to some of the biggest banks in recent months asking them to avoid originating loans that can be considered “criticized,” or debt seen as having some deficiency that may result in a loss. The regulators identified 42 percent of leveraged loans in that category this year in communications sent as recently as October.
Leveraged loans and high-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.
The average yield to maturity on new-issue first lien loans fell to 4.69 percent at the end of last month from 5.82 percent at the start of the year, S&P LCD data show.
Citigroup Inc. is forecasting U.S. companies will issue $375 billion of new loans next year, 15 percent less than what they raised in 2013, mainly because of the potential impact of regulations on collateralized loan obligations.
“While the eventual form of regulations is still unclear, its effect on leveraged loans will be greater than high-yield,” analysts led by Michael Anderson wrote in a Dec. 17 report.
Regulators are considering rules targeting CLOs, the biggest buyers of loans, as part of the financial reform mandated by the Dodd-Frank Act, that may force banks to hold onto portions of debt they sell to CLOs.
CLOs raised more than $76 billion this year, the most since 2007, according to Citigroup.
Implementation of these rules may reduce CLO formation by as much as $250 billion, according to a study published Dec. 18 by the Loan Syndications and Trading Association.
Even as loans receive greater scrutiny, firms such as Citigroup predict they will generate gains for investors.
Citigroup is forecasting leveraged loans to return 3 percent next year compared with 2.5 percent for junk bonds. Loans are poised to return 5 percent this year, after gaining 10.51 percent last year, according to the S&P LSTA Leveraged Loan 100 index.
“High-yield is about the only asset class where you can get current income with reasonable credit defaults in a slowly but steadily improving economy,” Tim Broadbent, head of Americas Leveraged Loan Syndicate at Barclays Plc in New York, said in reference to junk loans during a telephone interview.
The U.S. speculative-grade default rate was 2.4 percent in November, down from 2.5 percent in October, according to a Dec. 8 report from Moody’s. The bond rater estimates the measure will finish this year at 2.3 percent.
The Fed said it start cutting its $85 billion in monthly purchases of Treasuries and mortgage-backed bonds next month while holding its benchmark interest rate low, according to minutes from its Dec. 17-18 policy meeting.
Policy makers said in a statement it “likely will be appropriate to maintain the current target range for the federal funds rate well past” the jobless-rate threshold, especially if inflation stays below the Fed’s 2 percent target. The rate has been in a range of zero to 0.25 percent since 2008.
“We could potentially see more retail flows in 2014 than this year if people really believe the Fed will begin to raise rates,” Broadbent said.
Elsewhere in credit markets, the cost to protect against defaults on corporate bonds in the U.S. declined for the fourth day.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, dropped 1.1 basis point 63.3 basis points at 11:00 a.m. in New York, according to prices compiled by Bloomberg.
The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit 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, rose 1.38 basis points to 9.13 basis points. The gauge typically widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.