Investors are pulling their money out of securities that pool low-grade corporate debt, creating stress in one of the riskiest corners of North America’s debt markets.
Since mid-November, mutual funds and exchange-traded funds that allow retail investors to bet on so-called leveraged loans have seen a total of about US$9-billion in outflows by U.S. investors. That includes a withdrawal of US$2.5-billion from leveraged-loan funds in just five days in early December, setting a new weekly record for net outflows.
Leveraged loans are corporate loans issued with some of the riskiest terms available, and therefore the highest yields. The loans are often used to help fund mergers and acquisitions, and they are regularly issued to companies whose debt levels amount to more than three times their earnings before interest, taxes, depreciation and amortization (EBITDA).
Leveraged loans became more popular as the global economy found solid footing over the past two years, encouraging companies to borrow money to make deals. Interest rates, however, remained low, so investors craved securities that paid high yields. These loans also pay variable interest rates, which meant their quarterly payments would rise as the U.S. Federal Reserve and the Bank of Canada hiked their benchmark rates. The recent withdrawals from leveraged-loan funds mark a significant shift; as recently as early November, they were still receiving strong inflows.
The market for leveraged loans was worth US$1.3-trillion at the end of November, according to Lipper, a financial-services firm. It was the fastest-growing market of all the asset classes measured by the Fed, expanding by 12.9 per cent from the second quarter of 2017 to end of June, 2018.
Lately, however, there are signs that global economic growth is cooling. Even though the Fed raised interest rates again this week, the International Monetary Fund noted on Thursday that industrial production, world trade volumes and an important measure of manufacturing strength have all fallen sharply over the course of 2018. Heading into the New Year, there are also fears that a U.S. trade war with China will exacerbate the cooling.
Amid this shift, investors are pulling money from the riskiest types of debt. As this transpires, there are worries about the spillover effects. Debt markets offer snapshots into the availability of credit, and when borrowing costs rise, or when banks tighten their lending standards, it can have far-reaching economic consequences.
The worry is that investors glossed over credit risks during the frothy market, which helped fuel leveraged takeovers. In its inaugural Financial Stability Report in November, the Fed cautioned about weak credit standards. “Over the past year, firms with high leverage, high interest expense ratios, and low earnings and cash holdings have been increasing their debt loads the most,” the Fed wrote.
“The share of newly issued large loans to corporations with high leverage … has increased in recent quarters and now exceeds previous peak levels observed in 2007 and 2014 when underwriting quality was notably poor,” the central bank added.
In one illustration of the types of takeovers getting announced, Canadian waste-management leader GFL Environmental Inc. acquired U.S.-based Waste Industries in October for $3.65-billion, including debt − after GFL itself was taken over in a $5.1-billion buyout, including debt, by a set of private-equity backers in April, led by BC Partners and including the Ontario Teachers' Pension Plan. GFL’s debt is worth more than six times its EBITDA.
Credit-rating agency Moody’s Investor Service has voiced its own concerns about this market. “Leveraged loan covenants have been deteriorating for many years in a borrower-friendly market, leaving protections much weaker than they were in advance of the financial crisis,” the agency wrote in a November note to clients. (Covenants are stipulations written into loan agreements that dictate what levels of financial strength a company must keep.)
“As we reach the end of the credit cycle, loan-covenant quality is weaker today than it was in 2007 across all the risk categories that we analyze," Moody’s added.
As investors pull away from the leveraged-loans market, buyouts will be harder to execute, and that could dampen corporate earnings growth. It is also possible the companies that have already announced leveraged buyouts will struggle to make their hefty debt payments if the economy continues to cool.
Retail investors have invested in leveraged loans through mutual funds and ETFs that pool this debt. In Canada, iA Clarington Investments Inc., AGF Management Ltd. and Renaissance Investments, among others, offer “floating rate income funds" that hold these loans. Collectively, these funds have more than $5-billion in assets under management. IA Clarington, AGF and Renaissance all declined to comment.
It is possible, said Randy Steuart, fixed-income portfolio manager at Toronto-based Ewing Morris Investment Partners Ltd., that retail investors who have put money into leveraged-loan funds could find themselves in a situation similar to what transpired in Canada in 2015, when the preferred-share market experienced some disruption.
At the time, banks and insurers had issued billions of dollars worth of rate-reset preferred shares, whose yields reset every five years. Retail investors had bought these securities in droves coming out of the 2008 financial crisis. The expectation was that the quarterly rates they earned on preferred shares would rise once central banks started hiking amid strong economic growth.
The opposite happened. Instead of hiking, the Bank of Canada lowered rates in early 2015 to offset the impact of the energy-market crash. Preferred-share values quickly plummeted.
Now that global economic growth is cooling and fewer rate hikes are expected in 2019, a similar situation could unfold with leveraged loans.
However, there is an added risk with these securities. “Leveraged loans have even less liquidity than high-yield bonds … and in addition to that, they take even longer to settle,” Mr. Steuart said.
The worry is that mutual funds and ETFs in both Canada and the United States will have to sell loans in order to fund redemptions if the outflows continue. Yet, fund managers may not be able to do so quickly enough, because the median settlement time for a leveraged-loan trade is 11 days.
The Fed cautioned about this exact problem in its liquidity report, noting that “the mismatch between the ability of investors in open-end bond or loan mutual funds to redeem shares daily and the longer time often required to sell corporate bonds or loans creates, in principle, conditions that can lead to runs.”
Tim Kiladze