Put This On Your Radar

| August 31, 2018
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Leveraged Loans

While Moody’s may not have do a good job at understanding the credit cycle pre Global Financial Crisis, this piece seems to ryhme with other cautious memos.

What are they?

The loans have become popular in recent years because they carry floating interest rates, which better shield buyers from losses as the Federal Reserve tightens monetary policy. They’ve also been promoted as a safer alternative to high-yield bonds because they’re usually backed by collateral. It’s all led to an explosion in popularity, particularly through collateralized loan obligations, which are pools of leveraged loans divided into tranches.

Why the concern?

Recovery Rates: The Moody’s report serves as a sobering reminder that we’re at “a high point in the credit cycle” and that the good performance is unlikely to last. The analysts point to a potentially lethal mix of weaker investor protections, a smaller amount of unsecured debt to cushion losses and the demand for loans leading investors further down the rating scale. All told, the average recovery rate on U.S. first-lien loans will probably decline to 61 percent in the next downturn, compared with a 77 percent long-term historical average and 70 percent in 2008. Second-lien loans may recover only 14 percent, down from 43 percent.

And?

Low Covenant Quality: There are other ways that loan issuers are eroding creditors’ positions, effectively making them no more secure than high-yield bonds. By Moody’s estimate, overall covenant quality in leveraged loans is weaker today than in 2007 across every risk category.

Punchline?

“They are creating credit risks that portend an extended and meaningful default cycle once the current economic expansion ends. This would mean more defaults than the last downturn as well as lower recoveries, which would undercut a foundational premise for investing in loans.”

 

Stay Tuned, Disciplined & Patient! {TJM}

The Investor & Character Equation (ICE) | S + R = O

 

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