2018 was not a pretty year for financial markets with most assets classes recording negative returns. Thus, for 2018, ‘smart’ selection meant investors “should” have chosen leveraged loans. The theory goes that rising interest rates will generally hurt (fixed coupon) bond markets, but leveraged loans (as floating rate instruments) would benefit as central banks unwound balance sheets and increased interest rates.
Loans typically rank higher than bonds when borrowers go bankrupt, meaning that the recovery rate is higher. Today however, more than 50% of loans have no junior borrower to take the first hit. As a result, while historic recoveries are typically higher (around 75%), history should not be your guide for future recoveries. Indeed, according to a recent Moody’s report, 2nd lien recoveries are expected to fall from 43% to just 14% as loans are increasingly found at the bottom of capital structures. Given the strength of the economy, many of these facts were either not acknowledged or were deemed something to worry about on a more rainy day. Well, that rainy day could well have arrived as we have seen financial conditions begin to tighten over the last few months and with this there have been outflows within the leveraged loan asset class.
What makes the outflows all the more interesting is the growth in leveraged loan ETFs and mutual funds. At the start of 2000, there were only 15 ETFs or mutual funds dedicated to this part of the market compared to almost 300 today. The main holders of leveraged loans remain CLOs (collateralised loan obligations). Investors in CLOs have their money locked-in and need a secondary buyer of their share of the CLO to redeem their exposure, while ETFs and mutual funds promise instant access to liquidity despite many of the loans rarely trading. As a result, the liquidity mismatch between the vehicle and its asset could quickly transpire into a fire sale.
Recent data suggests we are starting to see signs of the leveraged loans market begin to unwind. Underlying assets and the vehicle in which those assets sit is part of the “dull” plumbing of financial markets, but investors should be mindful of liquidity mismatches.