Loan-Only Capital Structures on the Rise

October 10, 2019

Source: J.P. Morgan Source: J.P. Morgan

Senior bank loans are issued by companies to support business operations, finance merger and acquisition activity and refinance existing debts. Bank loans sit at the top of the company’s capital structure, are secured by the borrower’s assets and have priority versus unsecured debt in the event of bankruptcy, with higher recovery rates.

Typically, a corporate capital structure is composed of around 40% senior loans, 40% subordinated bonds and 20% equities. Since 2011, however, the “loan-only” structures, without any subordinated debts, have more than doubled in size, thereby reducing the loss cushion for the senior loan market broadly. This will likely result in lower recovery rates during the next credit downturn. Historically, loan-only issuer recovery rates are approximately 54%, significantly below loan & bond issuer recovery rates of 70%.

Companies are less attractive to borrowers in the high yield market and will finance in the loan market as an alternative. Even though subordinated bonds do not guarantee fewer losses on the senior loans, loan-only issuers are inherently riskier than loans with subordinated debts, as there is less cushion for the loan investors. Therefore, bonds would absorb losses before the loans.

Fundamentally, the loan-only structures are more common among smaller issuers. Bank loan borrowers are not transparent due to their limited access to financial data, lack of quarterly earnings calls and limited communication and guidance overall. Portfolio managers and loan investors will face more difficulties when monitoring these types of investments.

Technically, loan-only issuers tend to issue in smaller facility sizes, generally leading to low liquidity, which is crucial in the current market environment and economic cycle. Investors are focusing more on covenant-lite exposure and leverage, and neglecting rising loan-only structures. Investors should start to monitor loan-only structures as they track second liens and covenant-lite exposures in their portfolios.


Key Takeaway

Currently about 55% of the loan market consists of loan-only structures, compared to 30% in the last default cycle. Collateralized loan obligation (CLO) managers are the biggest buyers of leveraged loans and broadly own the risks from rising loan-only capital structures. Due to this large share of the loan market, it’s becoming more difficult to avoid investing in loan-only structures in CLOs. At this point, it has become more of a sector-wide risk rather than a bottom-up CLO manager-level risk. We are closely monitoring loan-only exposures as the record-long economic expansion begins to show signs of slowing.

Tags: loan market | loan & bond issuers

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