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In this issue of The Institutional Risk Analyst, we feature a comment from our friend Ralph Delguidice, a veteran fixed income markets observer based in San Francisco. He provides important detail and context to the evolving credit dynamics of leveraged loans and collateralized loan obligations (CLOs).
San Francisco | December has been a cruel month for investors in “Leveraged Loans” as winter came in like a lion, early and cold.
Primary and CLO spreads have exploded wider suddenly and loan prices have fallen below par going into the year end, stranding dozens of deals in bank warehouse lines and postponing the pricing on hundreds of other deals.
This has drawn considerable media and market attention of late, as the asset class has grown to $1.1 trillion and now eclipses the high yield (HY) bond market it used to shadow.
The Fed has been outspoken in their concerns as ETF and mutual fund buying has fed an insatiable demand for yield that naturally followed a decade of QE, and now with accommodation in process of being withdrawn the questions on possible systemic vulnerabilities are back front and center.
The question of where and how fast this market might be going is complex to say the least, and there is room to disagree to be sure. That said, a couple of things are important to keep in mind from a MACRO and structural point of view that may hold the answers:
The current correction is a natural and inevitable consequence of the widening in IG (investment grade), as the CLO markets are dispositive with respect to loan pricing and the quality of the CLO arbitrage—and expected loss adjusted returns—is a straight line-function of IG liability costs at the top of the “stack” (AAA, AA, A) that trade with corporate IG markets and FX swap costs
It is not an exaggeration to point out that AAA tranches are now priced entirely in Japan by a small handful of buyers—most notably Norinchukin (a huge deposit funded agricultural co-op) many of whom were big buyers the last time around in 2008. They forgive easily. But should FX swap costs and/or alternative sovereign yields offer a more attractive option the CLO bid could close altogether.
From a more MACRO point of view, the Fed hostility to leveraged loans (LLs) is actually ironic, especially given what is a clear and present intent on the part of the central bank to use the Non-banks (CLOs, hedge funds) as a loss absorbing “buffer” to protect the systemically critical GSIBs from the fallout as rates rise. This is perhaps the most important distinction of all for the asset class—as the Fed will not be quick to cut rates this time around in the face of non-continuous price discovery.
It has become evident that the dramatic easing of LIBOR in 2008 and 2016 was Central Bank driven and was critical to the “out-performance” of LL’s (vis-a-vis HY) in the past. Remember, cutting LIBOR rates offers IMMEDIATE relief to FRN’s that makes refianacings unnecessary. But this time around the Fed has neither the room nor the desire to bail out the LL markets. Either way, the Fed is comfortable with credit vol. contained in the non-banks that they view as expendable (at best), and that is a BIG RED FLAG.
Away from CLO’s--where volatility in the BB tranches was 8X the vol of the similarly rated loan collaterals-- the loan market has been saturated with demand from so-called SMAs (separately managed accounts). These are pension fund and family office investors who were attracted by the decade of flip-chart “out-performance” and who have joined HUNDREDS of brand-new—and totally untested—managers of hedge “credit funds” in what seemed to be an easy- Alpha trade.
The question of how well (and stably) funded these SMAs and hedge funds will turn out to be--and how serious is their intent --we will see in time. But retail fund flows are already suggesting significant outflows from the ETFs and loan funds, and this is not going to be lost on those institutions, especially those who may not have fully understood what it was they were buying into.
It is vital to remember that CLO deals that are half ramped (many of them) and that all own many of the same names already--are not going too be cash flowing fully to the residual (equity) tranche until they can manage to get fully loaned up. What this says about incentives (and other people’s money) as the market becomes volatile may be open to some debate, but transparency is in VERY short supply here, lags are long and management fees are, still, what they are.
The FED has 2 REAL questions where systemic risk and the potential for contagion are concerned that need to be watched carefully. The first is the question of liquidity transformation where the ETFs are concerned. Loan settlements can literally take MONTHS and ETF/Fund liquidity is minute to minute. Should the BKLN or SRLN ETF see outflows that test the integrity of sponsors and force-clear pricing the rest of the credit ETF/mutual fund market—8T$ AT LEAST— will certainly be impacted.
The second, and perhaps more important question (given the FED resolve in re the non-banks), is the degree to which so-called “collateral upgrades” have been done with CLO debt and LL’s themselves. In a nutshell, the now near total mandate to clear ALL interest rate and most credit swaps has created a pressing need for cash collateral to be posted at CCPs as initial margin. The BIS has estimated that swaps re-novated to CCPs have resulted in margin shortfalls are in the 4T$ range, and the primary users of swaps (insurance, hedge funds) are short of the acceptable sovereigns and cash to nearly this amount.
Over the past several years the custody banks and prime brokers have quietly managed to offer the users of derivatives the ability to swap corporate securities OF ALL KINDS WITH ALL RATINGS for UST collateral that can be REPOed for cash. Of course it is hugely profitable. The problems are equally obvious, and; ironically, are a repeat of what went wrong in 2008 as REPO funding market runs suddenly become, as Vince Lombardi once said: "not just everything, but the only thing.”
The above are some of the known-unknowns that LL and credit investors and will be dealing with in coming quarters. It is important to remember ALWAYS that these are specific issues that will be playing out against an economic backdrop that has become clearly hostile to credit of all kinds; and when all is said and done LL’s, CLOs and ETFs are all just different ways of packaging what is essentially raw credit risk—with few covenants and even fewer supporting market makers—into “securities” that are designed to appeal to retail investors that have been yield starved for more than a decade. If ever there was a text book smart money/stupid money trade, it is probably this market right now.
Several of the MOST experienced mangers—those FEW who actually were doing the trade just 2 years ago—have started CLO funds that will offer a designed predatory flexibility to buy busted debt and collaterals from the less fortunate and prepared. Ellington and Highbridge know the risks, and they are getting ready for a GOT-style Red Wedding.
My advice is don’t go -- more later.