With interest rates insanely low, many corporate borrowers have been refinancing with leveraged loans—despite significant risks—and investors are eagerly snapping up the debt
Corporate borrowers have seldom had it so good, particularly at the vast majority of companies around the world without an investment-grade credit rating. Alert finance directors at junk-rated firms have taken advantage of interest rates near record lows to refinance at least $250 billion worth of debt over the past half year. But tighter times may be coming, and the variable rates on many of the refinanced obligations may spell risks if and when rates move upward toward historical norms.
The focus of refinance activity has been the leveraged loan market, which from humble beginnings in the late 1980s has grown to a $1 trillion asset class globally. Leveraged loans are offered directly from banks to borrowers—unlike bonds, which are traded on public exchanges. But they are syndicated to a broad pool of investors, typically more than 100, or bundled into collateralized loan obligations (CLOs) that contain bits of various credits.
For borrowers, leveraged loans offer two significant advantages over high-yield bonds: They are cheaper, by about 100 basis points on average at the moment. And they can be repaid, or refinanced, at any time, increasing balance-sheet flexibility. The trade-off for lenders is more secure collateral and, particularly relevant in the current environment, a floating interest rate that can rise if central bank tightening lifts the LIBOR benchmark.
With the US Federal Reserve promising three rate increases in 2017, and the European Central Bank dropping hawkish hints of its own, that promise has gained in investor allure. Cash has been pouring into leveraged loan funds since late last year. That money has searched for outlets as companies, already well financed, issue relatively few new credits. A benign repayment outlook has further bolstered investors’ appetites. Leveraged loan default rates are running at just 1.5% compared to a 3% historical average, says Craig Russ, who oversees $35 billion in floating-rate assets at Boston-based fund manager Eaton Vance.
All those factors combined to spawn a mini-golden age for borrowers looking to refinance leveraged loans. About one-quarter of the entire asset class has been refinanced within the past six months at average savings around 75 basis points, Russ estimates.
“Since December we have seen excess demand relative to supply,” says Steven Oh, global head of fixed income at PineBridge Investments, who oversees an $8.5 billion leveraged loan portfolio. “Companies have been able to refinance at attractive rates.”
Some 85% of leveraged loans are underwritten in the US. In Europe, the market’s development has been hampered by a hodgepodge of national bankruptcy laws, and investor sentiment that has not fully recovered from the sovereign debt crises early this decade, according to Oh. Yet this instrument’s attractions are gradually increasing there too, opening the door for multinationals to float leveraged loans that match a euro earnings stream. “More CFOs now have the option of issuing loans in the US or loans in Europe,” he says.
GOLDILOCKS HOPES
Where the market goes from here is the subject of some debate. There are reasons for the good times to keep rolling. While lower refinanced coupons have eaten into returns for leveraged loan funds, managers say the funds will remain attractive to investors so long as distribution rates stay comfortably above 3%. They currently average in the 4% range, so no investors’ strike is on the horizon.
Market optimists look forward to a Goldilocks period with gradual rate hikes and low defaults shaping borrowing terms that suit both lender and debtor. “Barring some exogenous event, the US will be in a relatively low interest rate, and spread, environment for at least the next 12–18 months,” says John Bolduc, executive managing director at Miami-based H.I.G. Capital. “Markets are very borrower friendly, but not near the excesses we saw in 2006 and 2007.”
Skeptics see signs of the refinance rage cooling, however, as the companies most attractive to investors have already grabbed their opportunity. “Most of the easy refinancings are already taking place,” PineBridge’s Oh says. “We are entering a phase where supply and demand are in better balance.”
Even if the favorable macro backdrop persists, two more easily reversible factors have driven the hunger for refinanced leveraged loans. One is inflows from retail investors who, spooked by the prospect of central bank tightening, have shifted into an asset class where they traditionally represent just 10% or so of available capital. The other is a quiet period in new credit issuance, whether leveraged loans or bonds, which persisted through the winter. Retail money could retreat as its fickle owners find some new market passion. And primary debt issues might pick up as the midyear M&A season gains momentum, sucking financial oxygen out of the refinance market.
STORM CLOUDS
Peering further into the future, Moody’s credit analysts see a potentially much stormier forecast for lenders and borrowers in leveraged loans. Refunding needs for speculative-grade US companies will reach a record $1.06 trillion over the next five years, the ratings agency found in a February report. While total issuance of high-yield bonds is some 50% higher than leveraged loans, the loans account for more of the upcoming payments burden, $633 billion, thanks to shorter terms.
Issuance of CLOs, which generate most of the funding for leveraged loans, has actually been in decline since 2014, leaving a potential capital shortage as the big chunks of current debt start coming due toward the end of this decade, Moody’s warns. “Our Refunding Indices indicate refinancing conditions are less favorable than the historical norms,” the agency writes. “CLO investment capacity [could fall] well short of corporate refunding needs, especially starting in 2019.”
Investors so far shrug off this scenario as cautionary rather than predictive. “There’s always a theoretical risk, but the market is not creating conditions that would lead to a hard landing any time in the near future,” says Oh.
Still, companies might be wise not to place too many eggs in the leveraged loan basket. After all, investors are implicitly betting that the interest rates on those loans will rise before they are paid back, increasing costs for the borrower. Longer-term capital needs could be better addressed by bonds with a rate that is higher initially, but fixed for the term of the instrument.
Refinancing in the leveraged loan market may have looked like a no-brainer for a while. CFOs will have to start using their heads again going forward.
