As investors brace for slowing economic growth amid the unresolved U.S.-China trade war, leveraged loans originally worth about $40 billion are collapsing in value. Their face values recently dropped by at least 10 percentage points on average in only three months, and holders who try to sell them now may receive no more than two-thirds of their face values, according to analysis by Bloomberg.
A meltdown in these risky loans to already highly indebted companies has broad negative implications. The Bank of England (BoE) estimates that the combined global face value of these loans is $3.2 trillion, of which $1.8 trillion, or 57%, is held by banks, per Wolf Street, either as loans still on their books or bundled into securities called collateralized loan obligations (CLOs). “More and more managers are getting cautious out there...I think managers are quicker to sell when bad news comes out,” as Jeremy Burton, a portfolio manager at PineBridge Investments, told the Financial Times.
- The value of risky leveraged loans has been collapsing.
- Many of these are bundled into securities called CLOs.
- Banks are among the largest holders of CLOs.
- Widespread negative impacts on the markets may ensue.
Significance for Investors
Andrew Sveen, co-director of bank loans at Eaton Vance Management, agrees with Burton. “People want the well-performing loans, and are more wary of taking chances on the situations that have turned negative," as he told Bloomberg. The actual size of the leveraged loan market is a matter of debate, as is the actual definition of leveraged loan. The S&P leveraged loan index puts the U.S. face value at about $1.3 trillion, far below the BoE's $3.2 trillion global estimate.
Many of these leveraged loans financed buyouts of companies by private equity funds, as well dividends and other transactions that did not increase earnings, Bloomberg notes. The worst-hit sectors have been energy, consumer discretionary, and health care, though others have suffered as well.
A recent selloff in a group of leveraged loans with a combined face value of $23 billion reduced their average face value by 24%, according to Maggie Wang, a strategist with Citigroup, as reported by Barron's. The minimum hit for loans in this group was 10%. By contrast, the lowest-rated loans in the market (CCC+, CCC, and CCC-) saw an average price drop of just 5.8%. That's problematic because a majority of the leveraged loans that fell even more precipitously had ratings of CCC or better.
U.S. banks hold about $90 billion of CLOs, per a Federal Reserve presentation reported by S&P Global earlier in 2019. Those with the biggest exposure were Wells Fargo & Co. (WFC), $34.6 billion, JPMorgan Chase & Co. (JPM), $20.5 billion, and Citigroup Inc. (C), $18.1 billion. The same report notes that insurance companies hold about $122 billion of CLOs, per the National Association of Insurance Commissioners (NAIC).
The $23 billion batch of leveraged loans studied by Maggie Wang of Citigroup has been bundled into CLOs, and most CLOs can put no more than 7.5% of their portfolios in loans rated CCC. Thus, another big selloff might push many of these portfolios above that limit, requiring markdowns of 50% or more on those CCC loans, she notes.
If that happens, a vicious cycle of rating downgrades and interest payment suspensions on junk debt held by CLOs may ensue. This, in turn, is likely to cause a credit crunch for low-rated companies, as lenders and CLOs shun them.