The increased presence of CLOs in the market is also dragging down the aggregate credit quality of newly-issued leveraged loans, as they typically purchase B2/B3 rated bonds.Ĭhanges in the investor base offer another dose of uncertainty. There was USD236 billion of dry powder in private debt funds as of end-2017 (out of USD667 billion of total AUM). The large volume of investor cash chasing potential investment opportunities means that returns are likely to be lower. Zombies now account for 27 per cent of US small caps in the Russell 2000 index, up 10 per cent from ten years ago. Second, it keeps companies alive for longer than may be economically viable – leading to a preponderance of “zombies” or businesses that do not generate enough earnings to cover interest costs. Not only does that reduce their ability to pay, but it also increases the risk a loan will be subordinated by future borrowing. First, it could lead to lower recovery rates in case of default as weaker covenants can enable companies to issue more debt than would normally be the case. Such deterioration in companies' credit profiles has two potential consequences. Moreover, an increasing percentage of EBITDA used for calculating leverage ratios in takeovers is based on speculative forecasting like add-back synergies from buyouts or takeovers. The share of US leveraged buy-outs (LBOs) levered at six times EBITDA or higher has gone up to nearly 50 per cent in 2017 from 30 per cent in 2013. Īt the same time, leverage in private lending has climbed. The trend towards ever lower compensation for risk is evident across the credit market – internal rates of return (IRRs) on private credit funds have compressed in the face of rising capital inflows and increased competition for assets. Meanwhile, the spread on high-yield bonds has also narrowed significantly, a sign that markets are moving into the latter phases of the credit cycle. The spread per unit of leverage – how much more of a premium investors receive for choosing to invest in a more indebted company – has fallen to 76 bps, more than 25 bps below the average of the prior five years. In other words, it would take only a relatively modest deterioration in conditions for investors to lose all the additional compensation these assets are offering in exchange for increased risk and reduced liquidity.Īn additional concern is that the leveraged loan market tends to feature lower-rated borrowers, with the majority rated B, compared to BB in the high yield market. If defaults were to rise to 5.5 per cent from about 2 per cent currently – which would still be far short of the 10-15 per cent rates typically seen during recessions – and the recovery rate dropped to 50 per cent, the excess spread would be wiped out by the capital loss. The average spread at loan signing date has dropped to 383 basis points by mid-2018 from a peak of 473 basis points in March 2015. Source: S&P/LSTA, Moody’s. Using 12-month trailing default rates and applying recovery rates of 40 per cent for high yield and 70 per cent for leveraged loans in line with historical averages. That’s not to say that private debt is of limited appeal – it just means investors must be aware of the risks. Such conditions could exacerbate defaults, with serious implications not only for investors, but also for companies who rely on such financing structures and, potentially, for the health of the wider economy. It’s particularly worrying that issuers’ leverage is rising while credit protection is weakening. This, in turn, has broadened the range of investment opportunities, to a point where the private debt market has become too big to ignore.īut for all its dynamism, private debt remains untested - its ability to withstand a turn in the credit cycle has yet to be assessed. Disintermediation of the financial sector – a structural trend set in motion by curbs on bank lending – is encouraging companies that would normally have borrowed from banks to seek debt funding directly from investors. The high coupons on offer are part of the attraction as they enable pension funds to meet ongoing obligations.Īnother aspect of the private debt market's appeal is that it is becoming a deeper and more diverse asset class. Returns on leveraged loans and private debt are relatively high – in part to compensate investors for the assets being relatively illiquid – while volatility is lower than for high yield bonds. On the face of it, the private lending market has a lot to offer institutional investors in a world of near zero interest rates.
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