Diary of a Financier

Bank loans reach Neverland

In Dissertation on Mon 24 Feb 2014 at 06:42

Enough’s enough.  I just came out of my 4th meeting ytd with a floating rate bank loan portfolio manager.  They’re pushing this asset class ($BKLN) on retail and institutional investors so hard right now that the wholesalers are taking the PMs on tour with them…

We’ve owned senior floaters as 10-15% of our portfolio since early 2010.  I’ve seen all the funds in this style box.  They’re all currently trading at average prices of $100.5-101.5.¹  The underlying shouldn’t trade much over par—dare I say never—because there’s a perpetual refinancing risk to the buyer.

The big selling point for these loans has been “a hedge against rising rates.”  Retail investors getting sucked into these funds for that reason are in for a rude awakening for a couple of reasons:

  1. Almost all of these bank loans’ floating interest rates are tied to 3-month LIBOR, which is currently at alltime lows ~23bps—mostly attributable to global ZIRP and Fed Funds Rate guidance being maintained through 2016
  2. Almost all of these bank loans have LIBOR floors ~100bps, so it would take a material rise in the front-end of the yield curve before distribution cash flows increase with rising rates, which means principal values will drop as rates rise until LIBOR floors are exceeded (i.e. massive convexity)
  3. The underlying loans are pretty illiquid, so these funds all own 10-20% high yield junk bonds for liquidity (redemptions), which increases both credit and interest rate/duration risk

That all said, why own the asset class?  Seriously.  I mean, the yield curve’s steep with the front-end pinned. These LIBOR-based bank loans won’t help you hide from the rising 10-year ($TNX) everyone fears as a product of QE tapering. Plus, spreads are historically tight, and with prices over par, the only spread compression an investor will get comes from refinancing, which isn’t a beneficial tightening since it’s neither principal gain nor a yield pickup. On the contrary, the underlying bonds in your mutual fund have kept getting refinanced and replaced with lower-yielding issues.

If you think your PM is being really choosy and doing some top-notch credit selection, think again: the space has gotten so crowded that supply is tight, and refinancing is so high (71% in 2013) that portfolios are getting jammed with increasingly more expensive replacements.

In terms of the credit cycle, things seem pretty good.  Default rates are historically low ~2.5% annually with a relatively high recovery rate ~70%.  Flows into the asset class have been simply astounding too.

~~~~

Now that I’ve covered the background for the present state-of-the-market, consider how this marketplace mechanically functions.  These loans are for companies who can’t access the bond market for one reason or another (usually due to size or credit quality). So, they go directly to banks for funding.

First, a bank, called the “arranger,” works on underwriting or syndicating the loan.  In the meantime, an investment bank pre-purchases that loan at a spread, while concurrently arranging an investor(s) unto whom the IB itself can resell the block for another spread.  These secondary market investors usually agree to buy the loan on a T+20 settlement basis (in arrears) per a term sheet.

As you can see, these downstream arrangements are made while the bank’s still underwriting the loan. Much like the hunger games staged by a stock or bond initial offering syndicate, the secondary market’s appetite for an institutional loan is a major input as to the pricing (and frankly the creditworthiness) of the borrower’s initial terms. Unlike a normal security’s syndicate, these loans are contracts with a cumbersome settlement process that requires banks to warehouse them for weeks after issuance.

A lot can happen in weeks. As seen in the run-up to the 2008-09 financial crisis, while new loans sat in inventory awaiting securitization, banks were able to hedge their credit exposures using credit default swaps (CDS). As far as proprietary value-at-risk (VaR) models and regulators were concerned, a hedged exposure meant no risk. But, when a counterparty defaults on his contractual payment, a real risk is realized. CDS counterparty defaults (e.g. AIG) were one leg of the last banking crisis. A clog in the outflow of warehoused mortgage inventory was another (e.g. Countrywide, Merrill Lynch, Bank of America, Citigroup, Morgan Stanley, etc.).

~~~~

Yes, I’m drawing parallels between today’s institutional bank loan market and yesterday’s CDOs. That would require the massive scale, so let’s put this asset class’ size in context.  From 2003-07, $700B in MBS-backed collateralized debt obligation (CDO) were issued by US investment banks.  In 2013 alone, $670B in institutional bank loans were issued; $1.2T since 2011.

Those are outsized numbers.  Now, bank loans are part of the traditional commercial bank or S&L’s bread-and-butter.  Surely, this robust lending activity/credit extension is healthy for the real economy…?  Further, net issuance is a lot lower, since 71% of 2013 new issues were refinancings… right?  Yes, but all these numbers pertain exclusively to institutional bank loans, which represent large, secondary-market-tradable, leveraged loans and senior bank loans. Unlike the mortgages in CMOs/CDOs–which had [debatable] ratings from prime to Alt-A to subprime–all of these institutional bank loans are speculative grade (i.e. junk) by definition.

Today’s floating rate bank loan market smacks of the CDO market from yesteryear. Perhaps that’s a recency bias, but I hope the pang helps these players avoid a similar fate.  In fact, regulators called-out the leveraged loan market last year, talking it down off a cliff of deteriorating underwriting standards. Used mostly to finance LBOs, leveraged loans are a small corner of the institutional bank loan space, and the sub-category known as covenant-lite/PIK-toggles –which specifically troubled regulators in November 2013 — are even smaller.

Another strike against the asset class, cognitive dissonance shared among investors, underwriters, and even debtors seems to be driving this latest leg.  As evidenced by the fundamentals (spreads tightening & leverage ratios increasing) and technicals (flows & issuance surging), senior secured bank loans’ march higher continued unabated despite this chiding. 

–Romeo

¹Their benchmark, Credit Suisse Leveraged Loan Index, misrepresents the richness of this market, because it trades at $98.85 avp, which is weighed-down by big constituents like Lightsquared and Texas Utilities ($TXU), whose paper ~80c has been in slow default for more than 3 years.

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