Gadfly

Hot Loan Market Not Living Up to Promises

Yields haven't kept pace with Treasuries. That's a problem given the way some companies burn through cash.
From
Noah Berger/Bloomberg

Wall Street has a long history of selling products that promise protection that inconveniently runs out just as investors need it. The hot leveraged loan market seems to be the latest example of that. 

Leveraged loan issuance in the U.S. rose 49 percent in 2017 to nearly $1.5 trillion. And money has poured into ETFs that follow the sector. The PowerShares Senior Loan ETF, one of the most popular that track the sector, now has $7.7 billion in assets under management, up from $4 billion at the beginning of 2016, though that was as high as $9 billion mid-last year. A good deal of the momentum propelling investors into the fund and the sector in general is the idea that leveraged loans offer protection against the risk of rising rates. “Floating-rate loans provide the opportunity to escape the negative effect of rising rates,” Christopher Remington, an institutional portfolio manager at Eaton Vance, recently told Reuters, echoing something that has been regularly said by others as well.

Leveraging Up

Borrowing in the corporate loan market hit a high last year

Source: Bloomberg

Unfortunately, that doesn't appear to be the way things are playing out. In the past few months, as interest rates have started to rise with new velocity, the yields on leveraged loans, and their promises of protection, have not kept up. For instance, since their low in September, the interest rate on U.S. 10-year Treasuries have risen just over 60 basis points to a recent 2.65 percent. Yet the yield on U.S. leveraged loans is up just 22 basis points in the same period, matching only a third of the rise in rates.

The idea that leveraged loans offer protection comes from the fact that they are priced off a floating rate. The fact that in most cases it's the notorious Libor, the inter-bank lending rate that appears to have been regularly manipulated, should have already given some investors pause. Still, three-month Libor has risen to 1.8 percent from 1.3 percent in early September.

The problem is that the coupon that most leveraged loans pay is based not only on Libor, but also a contractual spread over Libor, and as demand for leveraged loans has risen, the spreads that borrowers have had to pay has continued to shrink. The average spread over Libor has dropped to 3.7 percentage points, according to S&P Dow Jones Indices, down 1.3 percentage points in the past year and a half. And leverage borrowers have taken advantage of that drop to refinance earlier loans, further eating away at yields.

Not Keeping Up

Leverage loan yields have not captured the increase in interest rates this year

Source: Bloomberg

This is, in part, how Wall Street is supposed to work. As more people want protection against rising rates, the price of that protection is supposed to rise. That's essentially what is happening when the spread drops. But it's not clear that the investors who rushed into the leveraged loan market, especially into ETFs that are forced to reinvest into loans even as their relative yields shrink, understood this. The PowerShares leveraged loan ETF has returned just 3 percent in the past year. And, as the recent drop in assets in the PowerShares ETF, suggest, some investors appear to be losing interest in the debt instruments.

That could be a problem for more than just investors in leveraged loans, which have become a bigger part of the corporate lending market in general. Stock investors, in part, are feasting on the fact that companies right now have a wide access to cash. It was recently reported that Uber blew through nearly $800 million in the last year's third quarter. Tesla's free cash flow was a negative $4 billion last year. And Netflix recently said it may hit that cash burn level this year.

Leveraged loans won't fund all of those losses. But the ability of companies to borrow vast sums of money, that they can then burn through, is in part dependent on deep debt markets. If leveraged loans continue to fail to live up to their promises, the market, at least for that debt, could get a lot more shallow.

 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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