Some Great Slides from the LSTA on the Leveraged Loan Market and CLOs

The LSTA is becoming one of my favorite sites on the web for the amount of information they provide to the public. For example, see below for some fantastic slides they put out from their recent conference and my commentary (Note - I have picked and chosen from a number of different presentation ... net/net all presentations are worth the read). Before I do that, I want to just post something I read from Hussman Funds "Weekly Market Commentary" as a backdrop:

"In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I'm not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording. Though I usually confine my views to statements about probability and "average" behavior, this becomes fruitless when every outcome associated with the data is negative, with no counterexamples. Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete. At present, the best argument against this outcome is that it is unthinkable. Unfortunately, once policy makers have squandered public confidence, the market does not care whether the outcomes it produces are unthinkable. Unthinkability is not evidence.

Moreover, from a valuation standpoint, a further market trough would not even be "out of sample" in post-war data. Based on our standard valuation methods, the S&P 500 Index would have to drop to about 500 to match historical post-war points of secular undervaluation, such as June 1950, September 1974, and July 1982. We do not have to contemplate outcomes such as April 1932 (when the S&P 500 dropped to just 2.8 times its pre-Depression earnings peak) to allow for the possibility of further market difficulty in the coming years. Even strictly post-war data is sufficient to establish that the lows we observed in March 2009 did not represent anything close to generational undervaluation. We face real, structural economic problems that will not go away easily, and it is important to avoid the delusion that the average valuations typical of the recent bubble period represent sustainable norms."
Those of the weak stomach should probably close their browser at this point...

Over the last 12 months, we have seen a dramatic issuance of senior secured and senior unsecured bonds in the high yield market. As can be seen on the chart below to the right, this has come at the expense of a drop in leveraged loans outstanding. Technically speaking, combined with the steady inflows of retail capital to the loan markets, the market has been quite strong: As most CLO's are in their reinvestment period, a reduction in aggregate supply of leveraged loans mean investors need to reinvest proceeds into existing secondary bonds where supply has been reduced thereby lifting prices across the board.

With that said, corporate issuance (loans and bonds) has been nutty up until April 2010:

As can see in the chart above, around April / May 2009, investors started adding corporate risk to their portfolio, and companies obliged them with high coupon paper that now still trades above par. In March 2010, things got very crazy and since have cooled down. From a loan perspective demand was very strong throughout that entire period. In my opinion, the reason for this comes from the following chart:

As can be seen, total LBO leverage in the US (I can not really speak to Europe here) is lower than it has ever been in the measured periods. That combined with healthy coupons, legitimate covenant packages, and a dearth of secondary supply has led to 9/10 leverage loan deals being well well oversubscribed.

The combined effects of increased issuance of bonds relative to loans, and generally speaking, a very healthy credit market in general up to April, has resulted in the "maturity wall" being extended:

Essentially what this chart is telling me is that 2011 and 2012 maturities have been pushed to 2014 and 2015. That may give us a bit of breathing room if we do go into another recession. Here is the aggregate maturity data:

Unfortunately, my favorite chart:

CLOs have a finite reinvestment period meaning that CLO managers can reinvest coupon / principal payments back into the market for a certain amount of time. Most deals are structured with a 5 or 6 year reinvestment period. With all the CLO issuance of 2006 and 2007, those reinvestment periods are ending.

This gets even more scary when you consider the make-up of the leveraged loan market and how CLOs have dominated in the past:

So what does this all mean> There are only a few logical conclusions that follow. Here are the facts in my opinion, supported by the charts above:
  1. There is a significant amount of loan paper that needs to be refinanced in 2014.
  2. Unfortunately, CLO's are currently structured will not be there to refinance said paper in 2014 because of reinvestment lock-ups. CLO 2014 refinancing capability is essentially nil.
With that in mind, what has to happen? There are a few possibilities:
  • Other investor types (hedge fund, retail, etc) grow dramatically to soak up CLO wind-downs
  • Loan issuers use equity issuance to de-lever balance sheets
  • CLOs return to their pre-Lehman glory
  • The amount of bonds in a capital structure increases dramatically relative to loans
  • Loan issues using the bankruptcy process to rid themselves of over levered balance sheets.
The only two realistic conclusions are the the last two above: Either there will be a significant amount of high yield unsecured and secured bonds issued or default rates will have to spike up.

In my opinion, it is hard to rationalize that bonds will soak up the needed supply. Given a stagnant economic growth rate and possibly another recession, I cannot justify investors adding exposure lower in the capital structure unless teased with a very high yields. If that were the case, and companies do "pay to play" as it were by offering very high coupon debt, default rates will naturally spike up as interest coverages will be extinguished by higher fixed costs. Taking it a step further, aggregate earning will be lower and hence forward valuations should be lower for the market (higher interest expense leads to lower earnings, higher interest expense leads to higher chance of default and a lower multiple).

So in the end, what do we have? More defaults. A lot more defaults. It won't happen in 2011 but will begin to tick up in 2012-2014. With that in mind, what kind of discount rate must one apply to recoveries for bonds maturing post this default cycle? Shouldn't the credit curve be massively steep for all but the safest issuer? I think so and I think that is what you will start seeing in the high yield market in the coming year. Short duration wins the day in my opinion.

How could I be wrong? Well, the three choices I believe are implausible at this point in time. Nonetheless, they are not a zero probability. Always invert. "How could default rates go lower in 2014?" - Economy roars back from a stagnant 2011/2012, investors are risk hungry again, and secured bonds wins the day - It is not a scenario I believe will pan out, but for full disclosure, I need to lay it out there. I'd be curious to our reader thoughts.

Quick Update: A reader writes in with a pretty decent argument....

One factor which is not exposed in “The Cliff Refined” chart is a CLO’s ability to push out loan maturities even after the reinvestment period has expired. Typically a CLO can hold loan maturities 6-7 years after the reinvestment period. While you can’t “repaper” the loan, you can push out the maturity through an amendment even after the CLO has gone “dark”. So what you will likely see is another round of amend/extends for the 2012/2013 maturities beginning shortly.

Couple that with your last chart and you have 75%+ of the loan market buyer incented to push out maturities. CLOs, to keep AUM high and push out equity option value; Banks/Insurance/FinCos, to avoid a default and capital write down; Prime Funds will be able to reinvest at a higher/market rate.

With all that said, this only applies to existing loans outstanding. Agree with you in that new loan creation will be hindered which should put a damper on the LBO market and M&A activity in general. And certainly interest burden is going up for everyone.


Anonymous,  6/30/2010  

great great post

Anonymous,  6/30/2010  

excellent post - I hope you continue this blog.

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Anonymous,  7/06/2010  

Why don't you believe refi through a combo of higher rates and more secured bond deals? Corporate leverage is not extreme (with the notable exception of some LBOs - your chart from LSTA notwithstanding). If the PIMCO new normal view is correct, the Fed will keep rates low for some time, so even historically high spreads will be manageable off such low bases. The HY market picked up much of the slack in 2009 with secured bond offerings; why shouldn't that be a reasonable possible outcome? Even in the equity mkt, more folks are looking at EBITDA vs just EPS. PE guys also have been supportive.

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hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.