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Leveraged loan buyers head for cover as fear ramps up over risky junk debt

Market jitters are the cause of a surprising turn of fortune for loans, traditionally considered a lower-risk way to invest in junk-rated firms

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Shutterfly, a photo printing company acquired in a risky leveraged buyout, had to slash prices on a US$750 million loan to 95 cents on the dollar, and even so left its banks stuck with US$255 million of loans they couldn't sell.

New York

LEVERAGED loan investors are getting increasingly angsty, and their fear may be a harbinger of more pain coming in credit markets.

Money managers are ploughing into the least risky junk debt they can find while avoiding the junkiest. Since the start of October, lower rated B loans have dropped about one per cent, while less risky BB-rated loans have lost just 0.26 per cent through Wednesday. An index of riskier loans is hovering near its lowest level relative to higher-rated loans since mid-2017, according to Credit Suisse total return index data.

Leveraged loans of all stripes are performing worse than junk bonds, which have risen about 0.1 per cent this month till Wednesday. It's a surprising turn for loans, which have historically been considered a lower-risk way to invest in junk-rated companies. That reduced risk comes from a key feature of the debt: it's usually among the first to be paid off if a company goes under.

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But as the loans have grown into a US$1.2 trillion market, safeguards and protections for investors have weakened. Money managers have grown more alarmed about how the debt will fare in a downturn.

"Leveraged loans may have a worse experience than usual because issuance volume has been large and underwriting has been sloppy," said Matt Eagan, a portfolio manager at Loomis Sayles & Co, which had around US$280 billion of assets under management at the end of June. "Bad news in leveraged loans could infect high-yield bonds."

Dropping prices

Fear has spurred some big price drops in loans recently. Loans tied to more than 50 companies have lost at least 10 percentage points of face value in just three months, according to data compiled by Bloomberg.

Some have dropped a lot more, with lenders lucky to get back just two-thirds of their investment if they tried to sell. That's unusual in the loan market.

As steep price drops have grown more common, investors have been inclined to take less risk in the market, and to favour safer loans instead. That helps explain why October has so far seen so many leveraged loans pricing at what is usually the lowest margin over the benchmark in the market - the most since the middle of last year when the loan market was blazing hot. As of the middle of this month, around US$7.2 billion of loans have been sold at that level, namely 1.75 percentage points above the benchmark London interbank offered rate, according to data compiled by Bloomberg.

Investor demand for stronger credits has also helped more BB rated borrowers reprice their loans at lower rates recently. In October, about 25 per cent of loans sold were repricings, a form of refinancing where investors agree to lower yields on their existing loans, the highest proportion since last October and up from zero in each of the first four months of the year, according to data compiled by Bloomberg.

"There is tremendous demand for credits that are deemed to be higher quality, and aversion for anything rated CCC or out-of-favour," said Steven Oh, global head of credit and fixed income at PineBridge Investments, referring to the lowest rating category.

Additional risk

There is plenty to worry about for US company debt in general. Corporate income is broadly falling, and debt levels are rising, according to a Morgan Stanley analysis of second-quarter earnings data. Some US companies are facing pressure on revenue from trade wars, and overall economic uncertainty has surged by some measures.

But leveraged loans have additional risks. Investor protections for the debt are much weaker than they were at the peak of the last credit cycle in 2007, Moody's Investors Service said in July. More companies in the loan market haven't issued other forms of debt such as corporate bonds, meaning there aren't other investors to absorb losses when companies go bust.

Adding to the potential pressure, the biggest buyers of the debt - money managers who package the obligations into securities known as collateralised loan obligations - have limits on how much of the riskiest debt they can buy. That can translate to steep price drops for loans when they get downgraded to somewhere in the CCC tier, because far fewer investors are willing to buy them.

Even loans graded B3, one step above the CCC tier, can have trouble finding buyers because any downgrade can trigger a price plunge. B3 loans are increasingly common in the market: they accounted for 44 per cent of new issuers in 2018 compared with 22 per cent in 2007, according to Moody's.

"When there is trouble, everybody moves to the exit and the exit is smaller than it used to be," Mr Eagan of Loomis Sayles & Co said. "You don't see demand and you just hit an air pocket."

Buckeye, Shutterfly

Investor fear has helped borrowers seen as relatively low risk. On Tuesday, Buckeye Partners LP, a pipeline company with some of the highest possible junk ratings, decided to borrow US$500 million more in the loan market than it had previously expected, after finding strong demand from investors. It cancelled a planned high-yield bond sale at the same time, according to people with knowledge of the matter.

Contrast that with Shutterfly, a photo printing company acquired in a risky leveraged buyout. It had to slash prices on a US$750 million loan to 95 cents on the dollar, and even so left its banks stuck with US$255 million of loans they couldn't sell.

Many of the weakest credits have been hammered for weeks. Since the end of August, B rated loans, towards the lower end of the credit spectrum for the debt, have fallen much more than BB. (The CCC portion, the lowest rated, is small enough that it may not represent overall market conditions.) In the bond market, the difference between the haves and have-nots is much less stark. BB bonds gained 0.3 per cent from the end of September through Wednesday, while B bonds lost 0.05 per cent.

For loans, part of the pressure on weaker credits has come from retail investors, who have been pulling money from funds. There's also been a little less demand from CLOs. Sales of those securities are down so far this year by US$10 billion.

"It's late in the credit cycle," said Jim Wiant, senior portfolio manager at MidOcean Credit Partners in New York. "Loans have returned 6.5 per cent this year, so investors with strong performance are less likely to take too much risk." BLOOMBERG