In today’s rising-interest-rate environment, senior loan funds’ low-interest-rate risk and enticing yields have made them alluring. Senior loans’ yields go up in lock step with short-term interest rates, offering an effective duration hedge, but they come with significant credit risks, as most of these loans are issued by companies rated below investment grade. Since 2010, their credit risk has gradually crept up. The relative debt loads to U.S. loan issuers’ cash flows had surpassed the precrisis high in 2016 and stayed at that level in subsequent periods through March 2018, according to S&P. The improving economic outlook and investor demand for yield facilitated this increasing debt load. Leveraged buyout activities and relaxing lending standards also contributed to this growth. On top of the credit risk, senior loans carry considerable liquidity risk.
The overall U.S. leveraged loan market leverage, measured by total debt/earnings before interest, taxes, depreciation, and amortization (EBITDA), is at its 14-year high, according to S&P. The preglobal financial crisis high was 4.9 times in 2007, which cratered to 3.7 times the following year. But this ratio slowly picked up and reached 5.0 times at the end of 2016, and it held steady at this level throughout 2017 and the first quarter of 2018. This elevated credit risk is partially offset by the issuers’ improved cash flow positions for debt service compared with 10 years ago. The average interest coverage ratio increased from 3.25 times to 4.75 times from 2007 to 2017, according to S&P. However, it is important to note that leveraged loan coupons float with interest-rate movements. If rates continue to rise, the interest coverage ratio is likely to decline.
While loans financing leveraged buyout transactions are relatively a small part of the overall senior loan market (accounting about 10% of new issuances from 2010 to 2017), this segment is a contributor to the market’s higher leverage. Virtually all companies that undergo large LBOs are senior loan issuers, and these firms are taking on more debt than they have in the past. Leverage ratios for buyout targets are at their highest level since the financial crisis, which could increase default risk. According to S&P, in the third quarter of 2017 the average U.S. leveraged buyout transaction was financed with a debt/EBITDA ratio of six. This level of leverage was only seen in 2007.
As more debt is used to finance acquisition transactions, it also pushes up the purchase prices of these acquisitions. The average purchase price multiple of proforma trailing EBITDA of these transactions was around 10.5 times in 2017, which is actually higher than 2007’s 9.5 times. While the higher purchase price does not directly increase default risk, it might be a sign that market participants are getting overzealous to get deals done.
Furthermore, there are no signs of slowing down both from leveraged buyout and senior loan perspectives. Acquisitions valued at more than $1.2 trillion have been announced so far this year, up more than 45% from a year earlier according to Dealogic. Virtually all of the announced transactions will be financed by senior loans, which is enjoying healthy demand because of its relatively high yield and floating-rate feature. Primary loan issuances jumped 60% to $1.4 trillion in 2017, roughly double that of 2007 volume, setting a new record, according to Thompson Reuters.
Covenants, or protective clauses for lenders such as a limit on a borrower’s debt level or dividend to equityholders, have been steadily weakening in recent years. This trend can potentially set the stage for lower recovery rates for investors if and when the underlying companies default. For example, the fourth-largest position of PowerShares Senior Loan ETF (BKLN), which has a Morningstar Analyst Rating of Neutral, is Change Healthcare. Change Healthcare was able to amend its loan agreement to eliminate the financial covenant, which required the company maintain a certain ratio of its earnings/interest expenses.
This change implies that lenders and investors of the loan have less protection if the company’s financial health starts to deteriorate. But it is also a reflection of confidence in the market that a majority of investors expect to be paid back in full even without those guards. During 2017, single B rated companies were the most active covenant-light borrowers according to JP Morgan and Morningstar. These types of covenant-light, issuer-friendly loans now account for a record 75% of the outstanding U.S. leveraged loans, according to S&P. This volume shows a stark difference when there were no covenant-light primary loan issuances at all in 2010, according to Fitch.
At the same time, this development presents opportunities for actively managed strategies to add value through fundamental credit analysis by avoiding issues that are likely to default. For example, from its inception in May 2013 through December 2017, actively managed First Trust Senior Loan Fund (FTSL) has experienced four issuer defaults compared with 16 defaults by the S&P/LSTA US Leveraged Loan 100 Index, which BKLN tracks.
Yields of newly issued loans have been consistently declining, which suggests that investors are potentially taking more credit risks while earning less returns. Compared with the first quarter of 2012, an average yield of broadly distributed loans, typically held by senior loan funds, came down to 4.85% from approximately 6%, while their average spread tightened to less than 350 basis points from over 450 basis points, according to Thompson Reuters. Over the same period, the average yield/maturity of the bank-loan Morningstar Category declined to 3.5% from 5.2%. This downward trend can be reversed by rising rates, which could increase the loans’ yields. But it is important to note that rates tend to change gradually.
There is an inherent liquidity risk for senior loans offered in an exchange-traded fund or a mutual fund wrapper. While these funds provide daily liquidity, their holdings don’t have a standard settlement period in contrast to corporate bonds, which settle within three days after a trade. The market average settlement time was 20 days based on LSTA secondary trades at the end of 2017. Because these loans are thinly traded, they are expensive to trade. For example, senior loans’ average bid-ask spread was 75 basis points as of March 2018, according to LSTA. These loans can be even more expensive for an index fund that regularly seeks liquidity.
The default rate for senior loans is low, but it does not imply they are safe, given they are predominantly issued by below-investment-grade companies. This credit risk is partially mitigated by borrowers’ pledged collateral, which can be seized and sold to pay back lenders, which tends to result in higher recovery rates if an issue goes into bankruptcy. According to JP Morgan, about 1.8% of loans defaulted in 2017. This figure is lower than the 10-year average from 2008 to 2017 of 3.1%. However, there is always a risk that default rates could pick up.
Senior loan products have been gradually taking more risks, evidenced by higher leveraged buyout valuation and relaxing lending standards. On top of increased credit risk, senior loan ETFs and mutual funds take on considerable liquidity risk. While senior loans do offer benefits such as low interest-rate risk and greater return potential than investment-grade bonds, investors should proceed with caution.
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Phillip Yoo, CAIA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.