Friday, December 21, 2018

UPDATED—"Why Leveraged Loans Are A Better Signal Than High-Yield Bonds"

Update after the jump.
Original post: 
Although leveraged loans won't lead to a systemic contagion (thanks Colby) they do have the potential to be a big mess and have been a fairly good indicator of risk appetite among the 'reaching for yield" crowd.

Peter Tchir at Forbes:
Oct 23, 2018, 06:57am
There is a strong belief that 'credit leads the way'.  As a credit person, I agree that is often, but not always the case.  What is also important is looking at the right part of the credit market.  While there has been a lot of discussion about the amount of corporate debt and even some focus on BBB bonds (which don't particularly scare me), much of the attention is focused on High Yield bonds.

The attention should be focused on the leveraged loan market which is now larger than the high yield bond market. According to Bloomberg, the leveraged loan market is now bigger than the high yield bond market, but barely gets the attention it deserves.  The Fed did notice this market last week in its statement, which I found encouraging as I've been highlighting the potential problems for several months.

The biggest problem is a lack of price discovery.  According to JP Morgan, the number of 'loan only' issuers is now greater than the total number of high yield bond issuers.  Many of the loan only deals are relatively small.  The fact that you don't have robust capital structures with bonds and loans, means fewer potential investors are analyzing companies.  That problem is amplified by the fact that smaller deals also tend to have fewer investors involved.  The demand from CLO's (Collateralized Loan Obligations) has been insatiable - creating so much demand, that price discovery has also been low.  Add to the fact that it is hard to know how 'senior secured' you are when there isn't unsecured debt below you in the capital structure, the dominance of covenant lite loans and you have a recipe for low transparency and little price discovery.

As om the close of business for the 3rd quarter, HYG (a high yield ETF) had short interest of 49% of the shares outstanding.  Almost half of HYG's shares were being shorted.  JNK, another large high yield bond ETF had 22% of its shares being shorted.
BKLN, a leveraged loan ETF (which tracks an index with only 100 issuers (and fewer issuers)), had just over 6% of its shares shorted....MORE
Update: However...
Contra that is this chart from SoberLook: