A $1.2 trillion market for loans made to already highly leveraged companies is showing signs of cooling


Debt-laden U.S. companies have been shunning the so-called leveraged loan market in troves lately, amid increased scrutiny of that segment of the market and the prospect that this week the Federal Reserve will deliver its first cut to benchmark interest rates in more than a decade.

Once a white-hot-area of the debt market, the roughly $1.2 trillion leveraged loan sector, has cooled considerably. The sector has seen a series of setbacks that include investors rejecting loose lending terms and dwindling new loan supply.

The pullback, however, may be music to the ears of regulators, analysts, lawmakers and others who have pointed to record loan volumes at highly indebted companies as evidence of a financial crisis in the making.

Leveraged loans — typically used in private-equity buyouts on companies that already carry a hefty debt load, have been the preferred route for businesses because of looser repayment schedules and borrower-friendly terms.

However, companies have been turning to other areas of the debt market for funding, including the high-yield, or junk-bond market, eschewing so-called leveraged loans.

At least part of the waning interest in leveraged loans comes as the U.S. central bank is set to cut benchmark federal-funds rates currently at a range of 2.25%-2.50%, by at least 25 basis points on Wednesday. Lower fed-funds rates can depress leveraged-loan investments because leveraged-loan rates are pegged to fed-funds sensitive Libor, the London interbank offered rate.

“The leveraged-loan mutual funds have had meaningful outflows once it became clear that rates were unlikely to go up, and more likely to even go down,” said Christina Padgett, a senior vice president at Moody’s Investors Service.

Including last week, loan mutual funds have seen a combined $43 billion in outflows since the start of the fourth quarter, or about 28% of their assets under management and all of their inflow gains over the past two years, according to J.P. Morgan analysts.

But outflows also have come at a time of diminished new loan creation. This J.P. Morgan chart shows an 65% drop in gross leveraged loan supply so far this year, with volumes running at a fraction of last year’s $510.6 billion volume.

J.P. Morgan data

Leveraged loan supply slump

Meanwhile, high-yield bond supply this year has already outpaced expectations. Goldman Sachs said on Friday that it was raising its forecast for high-yield U.S. bond issuance to $185 billion for the year. The bank’s earlier forecast was 12% lower, but brisk activity since January had “surprised to the upside,” analysts said in a note to clients. High-yield bonds tend to carry fixed coupons, compared with leveraged loans, which are usually calculated based on Libor plus a fixed premium on top of that rate.

According to Goldman, outflows from leveraged-lending funds have been one of the key catalysts for the shifting funding pattern.

“As leveraged loan fund low technicals have remained under pressure since late 2018, we think HY- rated borrowers have increasingly used the HY bond market for their funding needs,” Goldman analysts wrote.

Indeed, the junk-bond market has issued $142.2 billion of new debt since the start of the year, an 29% increase from the same period of 2018, according to Goldman data.

Dealogic, Goldman data

Brisk junk-bond issuance

U.S. junk bonds typically closely track the performance of U.S. stocks, which on Friday saw both the S&P 500

SPX, -0.16%

and Nasdaq Composite indexes

COMP, -0.44%

 set all-time highs.

Read: Stocks rise to new intraday record highs Friday

The global hunt for yield has been a driving force this year in U.S. junk bonds. Currently, a quarter of the world’s bonds offer negative yields, which means investors get back less than their original investment.

Check out: 25% of bonds in the world make lenders pay for the privilege of owning them, chart shows

Demand for high-yield bonds compressed spreads to 4.51 percentage points on Friday over Treasurys, or 21.9% below 12-month highs, according to J.P. Morgan data.

The spread on a bond is the level of compensation an investor demands over a risk-free benchmark, which makes it a key metric of investor sentiment.

“Spreads have been pretty tight versus where they have been,” said Lale Topcuoglu, a senior fund manager at J O Hambro Capital Management, in an interview. “If you can lock in a 10-year bond at these rates, you should be doing that all day long.”

In comparatively higher-quality corners of the junk category, borrowing rates have been in the high 4% to low 5% range, she added.

Worries about leverage lending have been voiced by an array of past and current regulators and industry pros, magnified by the implosions of a few companies tied to leveraged loans.

Last week, Sen. Elizabeth Warren issued a fresh warning on leveraged loans, saying they will play a role in the coming U.S. “economic crash,” unless something is done to rein in borrowing. Sheila Bair, former head of the Federal Deposit Insurance Corp., told MarketWatch last month that a bust in leveraged lending could rapidly hit the economy.

Read: Sen. Elizabeth Warren says ‘warning lights are flashing,’ cautions that ‘odds of another economic downturn are high’

The negative attention in leveraged lending has emboldened investors to push back on deal terms they deem too risky, even if that means holding up funding for a planned acquisition.

Last week, loan investors rejected terms of a planned buyout loan of up to $1.1 billion to Irish software company ION Group for its acquisition of financial media and data company Acuris, according to an LPC/Reuters report on Thursday.

The financing is currently on hold, according to the report.

Still, today’s lower rates are the biggest factor dictating borrower behavior, Topcuoglu said.

“The concerns around leveraged loans hasn’t really changed,” she told MarketWatch. “It has been the same story for about 12 to 18 months.”

Read: Here’s why the Fed and global regulators are ringing the alarm over leveraged loans and CLOs

“In this environment, it might make more sense to use high-yield bonds where demand has been strong, and the market is still looking for yield,” Moody’s Padgett said.

Source : MTV