Leveraged loans.
Reports today’s FT:
Leveraged loan slump throws up opportunities
The S&P/LSTA leveraged loan index suffered its worst month ever in October, losing 13.2 per cent and cementing a year-to-date decline of 20.2 per cent. The average loan is trading at 71 per cent of face value, far below the trough of 87 per cent seen in the 2002/03 bear market.
…
Nevertheless, some are spying value in the sector. “We are seeing high quality businesses that are overleveraged and their senior debt is trading at depressed or distressed levels,” says Luba Nikulina, senior investment consultant at Watson Wyatt.
On the face of it, loans trading at 70 cents on the dollar - even in the shadow of the current dire economic pall - might seem attractive. Recovery rates on leveraged loans are still relatively high. Using a conservative recovery rate of 50 per cent, current prices - on a simplistic level - are implying a default rate of 60 per cent.
(Aside: series 10 of the LCDX — and index of CDS on leveraged loans - is pricing in a slightly rosier 80 cents on the dollar compared to the S&P/LSTA index. )
Then, of course, there are all the usual tales of big investors setting up distressed/special situ funds to ‘take advantage of the opportunities in the market’. QED: latest $3bn venture of BlackRock Credit Investors II.
The narrative behind these various snippets being the fact that a great deal of trouble in the leveraged loan market has been caused by technical factors and not fundamentals: the unwinding-cum-painful-deleveraging of many a CLO, for example, or else, as the FT’s story details, the rapid exiting of hedge funds in the past month from various synthetic positions held with banks. QED: Black Diamond/Barclays.
But.
Leveraged loans have never been tested by so severe a market as the one upcoming. With it being a systemic crisis too, there’s no real way of saying how bad it could get.
Rating agencies are usually the go-to participants for default rate information, with Moody’s corporate default rate projection being the most highly and widely regarded. Currently the agency sees the speculative grade rate ticking up to 4.3 per cent by the year end and reaching 10.4 per cent by the end of 2009. Obviously that’s way, way below the rather apocalyptic rate loan prices seem to imply.
Fitch is much more bearish and sees the speculative default rate hitting 15 per cent.
But looking historically, those might indeed be underplayed. Certainly if you believe some of the strategists’ latest musings on how bad it might get, by historical crisis benchmarks.
On a purely technical level too, the leveraged loan market still has plenty of structures which may yet unwind and drive prices lower, and to hell with the fundamentals.
Quite apart from actual defaults most cash flow ABS CLOs contain rating triggers in their structures which if breached can force liquidation and/or portfolio rebalancings which would be damaging to the market.
In a note today S&P LCD estimates a critical point for most CLO portfolios being that at which 14.2-15.8 per cent of their portfolios are CCC rated credits:
With triple-C levels climbing in range of basket limits, managers are growing concerned. Few doubt that downgrade action will pick up in the quarters ahead as corporate earnings spiral lower. Assuming that this pace of CCC downgrades continues through May 2009, at which time David Wyss, S&P’s chief economist, thinks the economy will bottom out and begin recovering, the share of institutional loans that S&P rates CCC+ or lower will balloon to 12.8%.
At the critical 14.2-15.8 per cent level, based on recovery rates of just over 50 per cent on CCC credits, the average CLO portfolio would fail its overcollateralisation triggers and may have to cease payments to junior noteholders or else liquidate some portions of portfolios. Paradoxically those portions are likely to be the safest bits too, since all else will be pretty illiquid.
John Harper, Duke Street Capital:
I don’t think we have really seen much at all of what is to come in terms of stress and distress. We will see more companies getting into difficulties, starting to breach banking covenants or failing to keep up with principal and interest payments on their debt.
2009 is likely to be a difficult year. Banks tend not to foreclose retailers this side of Christmas. The first quarter of next year, when they are at maximum cash levels, we might see a wave of defaults._____
