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Credit: Not Lost in Translation

June 6, 2019 - This week, the LSTA hosted nearly 30 banks and managers and 800 attendees at the Annual “Investing in U.S. Loans" Conferences in Tokyo and Hong Kong. Below we recap the “aha” moments for members not fortunate enough to have traveled to Asia with us.

The negative loan headlines have made it to Asia and multiple panels tackled whether loans are systemically risky (they are not), whether CLOs are CDOs (they are not), and whether there is credit risk in loans (there is, but investors are well compensated for it). Regarding credit risk, there is broad acknowledgement that late cycle behavior is occurring: 30% of the market (and 15% of CLO holdings) are comprised of B3 credits and there are more loan-only capital structures. While less concerned about “covenant lite”, panelists conceded that loan documentation is looser, EBITDA adjustments are significant, debt incurrence capacity is non-trivial, and collateral sometimes can be transferred. Managers felt that these trends would lead to i) lower default rates over a longer period and ii) lower and more dispersed recovery rates. That said, it’s not at all clear when defaults would emerge: corporate earnings and cash flow remain supportive of credit. While leverage levels are high on new deals, companies with existing debt are deleveraging thanks to strong earnings. So default rates are low today and may remain so for a considerable time.

Having addressed credit, technicals took the stage next. December 2018’s three-point secondary pullback was all about technicals, leading to good buying opportunities for investors with cash and chutzpah.  (And, the opportunity was realizable: Secondary trading volumes hit record levels last year and the annualized turnover ratio topped 80%.) The early bird CLOs got the discount, with some actually improving overcollateralization, WAS and WARF… if they struck quickly.

But, in 2019, loan prices rebounded rapidly – to a point. With macro risk increasing, credit has repriced and thus secondary loan prices remain off their highs. Notably, the average price sits around 97 and “just” 27% of loans are priced above par, as compared to a peak of 72% last year. In the primary, new lending volumes are down to 2016 levels, due partly to the 4Q18 downturn and partly to reduced M&A activity. Meanwhile, an appreciation of credit risk (and a bias toward B3 issuance) has kept institutional spreads generally wider.

So how do Asian investors take advantage of these trends? In large part through CLOs – and they’ve had plenty of opportunity to do so this year. The $58 billion year-to-date new CLO issuance has matched last year’s run-rate. However, much of the 2019 CLO flow came from older 2018 warehouses; now that much of that vintage paper has made it through the market, a challenging arbitrage may slow CLO formation for a time.  Though CLO spreads have tightened a bit recently, they remain near their 24-month highs, reducing appetite for new issue, refinancings and resets. While all this may limit CLO activity in the coming months, managers remain confident about their ability to perform in the coming years.  A “lower for longer” default cycle married to dispersed recoveries should give active managers – and the locked-up capital structure  of CLOs – an opportunity to outperform.

The LSTA would like to thank our presenting sponsors (Alcentra, Ares, Bank of America, BlackRock, BNP Paribas, CSAM, Eaton Vance, Golub Capital, Investcorp, Marathon Asset Management, Morgan Stanley, Oak Hill Advisors, Octagon Credit, Pinebridge, Sumitomo Mitsui, Symphony Asset Management, Voya, DFG Advisors, GSO Capital Partners, Invesco, JP Morgan, MUFG Securities, Nomura, OZ Management, PIMCO, Shenkman Capital and Soundpoint Management) and platinum sponsors (Fitch, Standard & Poor’s, Refinitiv, Bloomberg, Cortland and IHS Markit) for making the conferences a success.

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