Are Leveraged Loans Becoming a Crowded Trade?

March 30, 2017

Are Leveraged Loans Becoming a Crowded Trade? Photo

Corporations have a variety of different options when it comes to raising outside capital. In the most basic form, they can issue equity or debt. When corporations elect to raise debt, they can issue it on a secured or unsecured basis and with fixed or floating rates. It is up to the management teams to choose the best option for the company at that time and to preserve its options for the future.

On the flip side, lenders, including banks and asset managers, must closely watch the credit spreads the issuers are borrowing at and ensure it fairly compensates them for the credit risk. One way to monitor the level of credit risk is total leverage (total debt/EBITDA*). Generally, the higher the leverage, the more risky the investment is for the lender (all else being equal). Therefore, the higher the leverage, the higher the credit spread should be, all else being equal. Recently, however, corporations have been accessing the secured leverage loan market with higher leverage as seen in this week’s chart, yet at tighter spreads. In fact, according to the J.P. Morgan Leveraged Loan Index, loan spreads tightened about 70 basis points (bps) since last summer.

According to Credit Suisse, corporations have been utilizing the leveraged loan market at record pace thus far in 2017 with $327 billion of new issuance year-to-date. This level of new issuance is 37% higher than the prior record of $238 billion, which was set in the first quarter of 2013. Corporations have been refinancing and re-pricing their existing loans (at tighter spreads) and that has contributed to about 70% of the new issuance volume.

Key Takeaway:

In the second half of 2016, leveraged loans seemed like a great place for asset managers to put capital to work. I liked them at that time for several reasons: they are higher in the capital structure, sometimes have restrictive covenants and they have floating rate coupons, which is beneficial in a rising rate environment. However, the aggressive spread tightening over the last few months, coupled with a decline in new issuance quality, has made the asset class much less attractive. I prefer taking risk in selective bonds in the high yield market where the new issuance quality has stayed relatively consistent and spreads have softened recently, as opposed to investing in what seems to be a more crowded trade in leveraged loans at this time.

Tags: Chart of the Week | Bonds | Credit spreads | Leveraged Loans | High yield | Credit risk

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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

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