As investors have continued to shy away from both conventional investment grade and high yield debt, interest in leveraged loans has exploded in recent years – a result of their floating rate interest which keeps up with rising Fed Fund rates within a largely unregulated industry in which non-bank entities (such as hedge funds) are among the main lenders – and as a result the size of the leveraged loan market recently crossed a historic milestone, surpassing the size of the entire US junk bond market.
In the process, numerous warnings have been sounded about this frothy growth in the leveraged loan space, from such luminaries as Howard Marks, Scott Minerd and Daniel Tarullo, to the Bank of International Settlements, and the Fed itself.
And investors have noticed.
According to IHS Markit, the short interest in the Invesco Senior Loan ETF, the largest vehicle backed by leveraged loan debt, has hit a record high with borrowed shares surging to 32 million.
And, as Bloomberg notes, the rush to bet against the fund, ticker BKLN, has been so aggressive that 88% of shares available to lend from institutions have already been claimed, according to IHS Markit director Samuel Pierson. “While the ETF is still easy to borrow, there will be some friction soon if demand continues to rise” from short-sellers, said Pierson.
Why short the ETF? Simple: since it is virtually impossible to borrow the loans that underline the fund, short-sellers are forced to use the ETF, Pierson said, although he noted that it’s unclear whether the positions are outright shorts, a hedge against specific loan exposures or part of an arbitrage strategy.
Meanwhile, as the bears assault the ETF with a barrage of new shorts, the long are scrambling: in the week ending Oct. 25, investors pulled a record amount of cash from the $6.6 billion fund.
The growing backlash against what Bloomberg dubs “one of 2018’s hottest investments and go-to financing route for junk-rated companies” has been mounting in recent weeks, amid rising fears – echoed by the Fed itself in its most recent minutes – that the relentless demand from Wall Street’s CLO machine and other yield-starved investors who have shifted out of fixed-coupon debt and into floating, has given rise to irresponsible lending practices.
To Peter Tchir, head of macro strategy at Academy Securities, leveraged loans may be the first domino to fall when the business cycle turns.
“They tend to be less transparent and have weaker price discovery,” he said. “You can watch high yield as much as you want, but if there is a credit problem, the epicenter will be the leveraged loan market.”
Others are just as concerned: in his September memo to clients, Oaktree’s co-chairman Howard Marks observed that “hrowth has been in levered loans, not high-yield bonds,” adding that “the risk level has risen in loans while remaining stable in high yield bonds.” Some other big picture observations from his memo:
- Total leveraged debt outstanding (high yield bonds and leveraged loans) is now $2.5 trillion, exactly double the amount in 2007. Leveraged loans have risen from $500 billion in 2008 to almost $1.1 trillion today.
- Most of this growth has been in levered loans, not high yield bonds. Whereas the amount of high yield bonds outstanding is roughly unchanged from the end of 2013, leveraged loans are up $400 billion. In the process, we think the risk level has risen in loans while remaining stable in high yield bonds. These trends in loans are due in large part to strong demand from new Collateralized Loan Obligations and other investors seeking floating-rate returns.
- “Some $104.6 billion of new [leveraged] loans were made in May, according to Moody’s Investors Service, topping a previous record of $91.4 billion set in January 2017, and the pre-crisis high of $81.8 billion in November 2007.”
- The average debt multiple of EBITDA on large corporate loans is just above the previous high set in 2007; the average multiple on large LBO loans is just below the 2007 high; and the average multiple on middle market loans is at a clear all-time high.
- $375 billion of covenant-lite loans were issued in 2017 (75% of total leveraged loan issuance), up from $97 billion (and 29% of total issuance) in 2007.
Guggenheim’s Chief Investment Officer, Scott Minerd, is just as gloomy: when asked during a recent interview with Goldman Sachs what aspect of capital markets he is most worried about, and whether he is worried by the growth of non-bank lending, he had a simple answer: leveraged loans.
Fifteen years ago, around 80% of all syndicated loans remained on bank balance sheets through a “pro-rata” tranche that was a revolving credit line or an amortizing term loan; now, 70-80% of syndicated bank loans are outside of the banking system, meaning that the pro-rata tranche is much smaller in comparison to the institutional loan tranche that is distributed among non-bank lenders. We’ve also seen estimates that the private debt market has grown to around $400bn to $700bn in size—larger than the size of the bank loan market in 2007. That has made it harder to trace credit risk and maintain credit standards.
Meanwhile, innovations like bank loan ETFs have moved credit risk into the hands of retail investors. That’s something we didn’t have to worry about in the last major crisis in corporate credit, in 2001/02.
His conclusion: “We’re in uncharted territory.”
He is right, of course, and as more investors realize that they are piling on the shorts in what will be ground zero of the next credit crisis.
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