After both investment grade and high yield bonds got crushed in the past month with spreads blowing out to multi-year wides and generated negative YTD returns as Morgan Stanley now sees the bear market gripping credit accelerating into 2019, many traders were wondering how long before the final bastion of the credit bubble – leveraged loans – would also pop.
It appears the answer may be “now” because as Bloomberg reports, no less than 4 leveraged loans have been pulled this month as a result of the turbulence gripping the broader credit market, the highest number of pulled deals since July when five deals were pulled. Expect more to come.
This comes as the price on the S&P/LSTA U.S. Leveraged Loan 100 Index has plunged since the start of October, when it was just shy of par, to 97.28, the lowest price since November 2006!
Diversified manufacturer Jason Inc. became at least the fourth issuer to scrap a U.S. leveraged loan this month according to Bloomberg, which writes that the company had kicked off the syndication process on its amend and extend on Nov. 13 was seeking commitments from new lenders by Nov. 20
Additionally, in the last two weeks, Perimeter Solutions pulled its repricing attempt, Ta Chen International scrapped a $250MM term loan set to finance the company’s purchase of a rolling mill, and Algoma Steel withdrew its $300m exit financing. Global University System last week also dropped its dollar repricing, but successfully completed a repricing of its euro tranche.
Prior to this string of deals getting shelved, the last pulled loan deal seen was Apergy’s $395m loan repricing in late October. Before that there hadn’t been a scrapped transaction in the market since late August.
The shift in market dynamics from sellers to buyers was on exhibit last week, when eight loans flexed wider while none flexed down – the first week when no borrower friendly changes were made since at least August.
Leveraged loans hitting a brick wall is bad news for CLO investors – the biggest source of leveraged loan demand – who should position themselves higher in quality in the face of late-cycle credit risks, credit curve steepening and spread widening, Morgan Stanley write in its 2019 outlook report on the CLO market.
According to MS analysts Johanna Trost and James Egan, the focus of the market will shift from technicals to fundamentals – the same argument noted by Adam Richmond in his broader credit outlook for 2019 – warnings that the risk/reward for CLO equity doesn’t look favorable against the late-cycle backdrop as “cash distributions have been trending lower and liquidation values are 10x exposed to deteriorating loan pricing and loan losses.“
Morgan Stanley also expects new issue supply to fall to $90 billion for 2019 from $126 billion this year, with less investor demand for equity cited by MS as the main risk factor to volumes, which may drive the difference between the base forecast and bear case of $60BN (the bull forecast $120BN). Meanwhile, the refinancing/reset split meanwhile will skew to more refis next year, as managers will need to “get more creative” in a challenging deal pricing environment and the cost savings to equity at the shorter end of the term structure will incentivize refi activity.
As for the leveraged loans underlying these CLOs, Morgan Stanley has been warning that covenant quality is weaker than 2007, as the cushion beneath the average loan is lower while 1st lien leverage levels are higher. As Richmond noted earlier, “48% of LBO transactions are levered over 6x versus 51% in 2007, but as a part of those leverage numbers, 27% of deals have Ebitda adjusted for prospective cost savings/synergies versus only 15% in 2007.”
Still, don’t expect a surge of lev loan defaults, yet: the 2019 leverage loan default rate is estimated to be at 2.7%, although as the bank cautions “spreads move before defaults.” These should rise more meaningfully in 2020 and peak in 2021 in a longer “but less steep default curve than in 2008/2009.”
As a result, the bank recommends defensive positioning “in AAAs instead of junior AAAs or AAs because of the better liquidity and lower spread duration, and in shorter-dated paper because of lower MtM risks and a relatively flat AAA term structure.”
Finally, in what may come as a surprise to some, the following table shows that in the lev loan market, the tech sector comprises the highest share, has grown the fastest, and has 29% B- or lower rated facilities by par.
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