Leveraged Loans–Oversold?

It seems that at least once every week we see an article extolling the virtues of leveraged loans.  They offer generous yields and, via the floating rate features, protection from rising rates.  What could be better?  Two days ago the WSJ reported that the loan index has posted a YTD return of 4.3% while almost all other bond sectors have negative YTD returns.  The strongest classes of CLOs have YTD returns of around 2%.

Those are impressive returns for a period in which Treasuries have returned -2.5% and investment grade corporates -3.3%.  Even the high yield market’s return of 1.5% cannot match the loan returns–or can it.  Loans are regarded as short duration securities.  In the high yield bond sector, the shorter durations have produced returns comparable to those from the loans.  The 1-3-years high yield index posts a YTD return of 4.2%.  The 3-5-year index has a return of 3.2%.  And, I would argue that those segments of the bond market entail much less risk than the loan market.

In high yield, the major risk is credit risk, not the risk of rising rates.  If, some day, the economy falters and/or there is a credit event, loans would be expected to perform far worse than high yield bonds, especially short-duration bonds.  Recall the terrible returns from loans in 2008-09.  In the event of a credit scare, loans become illiquid much more rapidly than bonds.  And we know what happens to bids for relatively illiquid risky  securities.

There is much speculation about what will be the next financial crisis.  Some market observers point to the corproate debt market because so many companies have become very highly leveraged.  If there is any merit to that argument, one should be especially wary about the loan markets, where covenant protection has vanished and issuance has been exploding.  Much of that issuance has gone into CLOs and ETFs.  I worry more about the ETFs.  Buyers of the CLOs are usually professional managers who can assess risks and have some staying power.  Buyers of ETFs are less sophisticated and might sell at the first signs of trouble.  Then, the relative illiquidity of the loans could become a big problem.

For now, the outlook for the economy appears favorable to high yield loans and bonds.  But, by the time we recognize that the outlook has deteriorated, those markets will probably already have begun to weaken.  It might be prudent for those investors who have captured the good returns from loans to begin switching to the less risky segments of the high yield market.  Short-duration bonds are a sensible alternative.

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