The loan market is the septic tank for sub-single B LBO financing

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

Portfolios of single name IG CDS are less complex and more liquid than CLOs

I was a fully paid-up member of team transitory and I was wrong: we have an inflation problem. It is not merely that supply-chain disruptions will be prolonged — possibly indefinitely — by China’s zero-tolerance approach to covid and exacerbated by events in Ukraine; nor that fallout from the Russia-Ukraine war will cause energy, food and commodity prices to spike. It is that there are no easy short-term fixes to any of the price pressures the crisis has unleashed.

The changes we are experiencing are secular. The ability to globalise factors of production allowed companies to scour the earth for the lowest-cost option and did much to eliminate price pressures over the past decade. But the pandemic brought the shortfalls of this strategy into sharp relief, and the war has cut the communication lines that made it possible. Even if Russia and Ukraine reconcile, we will not return to the status quo ante.

However, at least as far as the US goes, household and corporate accounts as a percentage of GDP are running at about 250% of pre-pandemic levels. The household debt service ratio, excluding the pandemic dips, remains at its lowest level since before 1980, while delinquency rates on credit cards, auto loans and mortgages still show favourable trends.

Consequently, rates are on the way up, with six 25 basis point hikes necessary to get Fed Funds to the median 1.75% by year-end in the Fed’s latest dot plot. Yields on the 10-year Treasury have jumped 55bps since the beginning of the month to 2.37% and probably have further to go. (They last peaked at around 3.2% in 2018.)

If current core inflation of 5.4% (PCE Core Deflator) proves sticky, the Fed may be forced to hike more aggressively to avoid running an accommodative policy in real terms.

Accessing investment grade risk

This presents a quandary to IG investors. The war has pushed IG spreads to a point where they are cheap both to HY and rate volatility; spreads on the US IG index are at 88th percentile on a five-year range. In addition, IG spread curves have flattened to a level not seen since the outset of the pandemic. At the same time, low-cost maturity extensions during the past three years, combined with record cash balances at IG corporates, make near-term default risk extremely remote, even if the economy suffers a shock. But accessing IG through cash means taking mainly fixed-rate exposure and facing value destruction as rates rise.

Understandably, the rate threat has sent investors searching for floating-rate options in leveraged loans and CLOs. However, this typically means a significant trade down in terms of the underlying asset quality. While the quality of the HY bond market has improved over the past decade, with the proportion of paper rated single B or below falling from over 65% to 55%, the proportion of new loans rated in this band has soared to 75% from under 55% as the loan market has become the septic tank for sub-single B LBO financing.

If the economy falters, the cracks are likely to manifest here first. Nor should investors necessarily take comfort in the structural seniority of loans. Ever more permeable structures and porous covenant packages have seen first-lien recovery rates fall from over 70% to under 60% between 2010 and 2020.

Lever IG single names rather than buy CLOs

CLOs (depending on which part of the structure the investor holds) may be able to offset higher default risk in the underlying loans with over-collateralisation, while junior tranches benefit from structural (non-recourse) leverage. However, these are complex instruments, with implicit structural conflicts of interest and underlying assets that are relatively illiquid (especially in market dislocations).

IG single-name CDS, which disaggregate rate risk from spread risk and, as unfunded instruments, can be easily leveraged, provide a more liquid (and higher quality) alternative. In addition, their availability across the maturity spectrum facilitates capital appreciation from roll-down as credit curves normalise. Leveraged portfolios of single-name IG CDS present a structurally less complex and more liquid alternative to CLOs. In terms of risk-adjusted returns, they compare (favourably) with CLO equity.

Indeed, given their markedly different underlying asset pools they may be seen as a complement/diversifier to a CLO alternative. So, there is no need to abandon the compelling risk reward trade-off in IG corporates — even if you made the right call on inflation.

Share this article:

${prev-page}

${next-page}

Browse more Creditflux newsletters

Global credit funds & CLO's

April 2022 | Issue 244

Published in London & New York.