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US Leveraged Loan Market Hits Breaks as High-Profile Headlines Continue

loan index

Amid mixed corporate earnings and more flashing-siren headlines about the market, U.S. leveraged loans lost 0.12% today after slipping 0.04% yesterday, according to the S&P/LSTA Leveraged Loan Index. A 12 bps daily drop for the usually less-volatile loan asset class is relatively steep.

Loan returns are –0.09%  month to date and a comparatively strong 3.91% YTD.

Source: Instinct Loans Market Monitor/BAML

To be sure, it was a buyer’s market today, with sell interest in the secondary swamping bids for leveraged loan paper, according to the Bank of America Merrill Lynch Instinct Loans Market Monitor, a trading platform.

The big news recently, of course, was Sen. Elizabeth Warren on Wednesday calling out the leveraged loan market in a letter to federal regulators, citing as areas of concern covenant-lite loans and the booming collateralized loan obligation (CLO) market. Warren became the latest in a series of high-profile criticisms of the asset class over the past month or so. As did others, Warren pointed to events in 2008, leading up to the financial crisis, as one reason for concern about today’s long-running bull credit market. These headlines have contributed to a slowdown in investments in the market, managers say.

How concerning the recent market direction is can be up to some debate. The Loan Syndications & Trading Association, a trade organization for the asset class, responded yesterday to recent concerns regarding leveraged loans, pointing out, among things, that

  • Today’s market, despite its $1 trillion-plus record size, has grown at a relatively modest pace since 2007-08
  • Overall speculative-grade corporate leverage is lower now than before the financial crisis
  • Pre-crisis CLOs performed extraordinarily well after the financial crisis (these vehicles often are conflated with their second cousin, the CDO, whose role in the crisis offers far less opportunity for debate)

You can read Sen. Warren’s letter to regulators here, and the LSTA’s commentary on recent concerns about the market here.

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High-grade: Tobacco bond spreads gap wider as regulators eye menthol ban

Credit spreads referencing tobacco concerns gapped wider this morning as the U.S. bond markets reopened, as investors react to market speculation that the U.S. Food and Drug Administration (FDA) may propose a ban on the use of menthol cigarettes in the days to come, building on its 2009 ban of other-flavored cigarettes “known to appeal to youth and young adults.”

Bonds backing British American Tobacco (BATSLN) were tagged with week-to-week moves as much as 30–40 bps wider. BAT Capital 3.557% notes due 2027, which were priced last August at T+130, traded today at T+175–180, from T+145–150 a week ago, and T+135 in early August, trade data show. The issuer’s 4.54% bonds due 2047, which it placed last summer at T+170, traded today at T+230, from T+190–195 last week, and T+175 in early August.

BAT printed both bond issues as part of a blockbuster, $17.25 billion offering across eight tranches backing its acquisition of the 57.8% of Reynolds American that it did not already own for roughly $49.4 billion.

S&P Global Ratings in May noted that the acquisition of the Newport brand gave the company “the No. 1 position in menthol cigarettes, a growing category in a declining market.”

Five-year BAT protection costs in CDS are near 100 bps this morning, from 77 bps a week earlier, and 67 bps in early August. Analysts today noted that BAT is particularly exposed to menthol regulatory risk, as it derives more than one-fifth of its overall operating profit from U.S. menthol, slightly more than Altria and roughly double that of Imperial Brands.

Altria five-year CDS this morning lurched higher by 18% to test 45 bps, from 36 bps last week. Imperial CDS neared 90 bps, from 77 bps last week.

The FDA reports that 19.7 million people in the U.S. are current smokers of menthol cigarettes, and that “youth who smoke are more likely to smoke menthol cigarettes than older smokers.” It said more than half of smokers aged 12–17 smoke menthols.

The FDA’s promotion of menthol awareness comes as it also plans a public hearing on Dec. 5 to discuss its efforts to “eliminate youth e-cigarette use.” The agency last summer announced a plan that it says provides a “multi-year roadmap” to achieving its goal of lowering nicotine in cigarettes to “non-addictive levels,” while also addressing “known public health risks” associated with electronic nicotine delivery systems (ENDS). Spread moves across the sector’s bond stacks were modest at the time, as investors eyed the many caveats that might shelter producers from immediate operational strains.

In an analyst briefing in October, BAT detailed its intensifying outreach to the FDA to manage regulatory risk, citing 16 “engagements” with the body since 2016, versus 12 in 2009–2015. It downplayed the risk that regulation would be a negative for the industry and BAT, arguing that “the process is evidence based, complex and will take a long time.” It noted that the rule-making process has as many as nine steps, and that just the preparation of a proposed rule can drag on for years.

External analysts today noted that the industry likely would flood the courts to mitigate any impact, potentially protracting the implementation of any material regulation. — John Atkins

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LibreMax Capital to acquire Trimaran Advisors and $3B of CLOs

LibreMax Capital LLC has announced that it has entered into an agreement to acquire Trimaran Advisors from KCAP Financial.

Trimaran currently manages six CLOs totaling about $3 billion in assets.

Following the transaction, Dominick Mazzitelli, Chief Investment Officer and head of the firm’s CLO platform, will continue to lead that business alongside the existing management team.

LibreMax Capital is a New York–based asset manager with around $2.9 billion that specializes in structured credit. LibreMax’s CIO is Greg Lippmann, who was previously the global head of Asset Backed Securities Trading at Deutsche Bank.

Closing is expected around year-end with Schulte Roth & Zabel LLP serving as legal counsel for LibreMax. — Andrew Park

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Leveraged Loans: Covenant-Lite Issuance Levels Off, Though Remains Strong

cov-lite loans

Some man-bites-dog news in the leveraged loan world.

Technically, the share of covenant-deals underlying the U.S.  market has dropped, the first time that’s happened in 18 months. Before alerting the mainstream financial press, however, we’ll note that the cov-lite share of the market dipped a scant 0.2%, from 79% in September to 78.8% in October. To be sure, cov-lite remains the norm in the new-issue market, as deal structure and documentation continue under pressure, amid sustained investor appetite.

Some background. Historically, leveraged loans have featured maintenance covenants, which are relatively restrictive. They would require an issuer to meet regular financial tests regardless of whether the issuer was undertaking some action (issuing a dividend, for instance).

Today, however, a covenant-lite loan is more likely to feature incurrence covenants, which are less restrictive. These generally require an issuer to be in compliance only if takes a particular action (paying a dividend, making an acquisition, issuing more debt).

This scenario has prompted investors to complain that, in theory, cov-light issuers today can come closer to default before lenders and investors have any recourse, or even receive warning of possible default. – Staff reports

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US High Yield Bond Funds See $1B Investor Cash Inflow

hy funds
U.S. high-yield funds reported an inflow of about $1 billion for the week ended Nov. 7, according to weekly reporters to Lipper only, reversing last week’s outflow of roughly the same amount and narrowing the year-to-date total outflow to roughly $24.8 billion.

The year-to-date total exit continues to mark an unprecedented volume of outflows from high-yield funds (last year’s total outflow of roughly $14.9 billion stands as the largest exit on an annual basis to date).

ETFs led the inflow this week, with a gain of $631 million, while $409 million entered mutual funds.

The four-week trailing average narrowed to negative $480 million, from roughly negative $2 billion in the previous week.

The change due to market conditions was an increase of $1.15 billion, according to Lipper.

Total assets at the end of the observation period were $198.8 billion. ETFs account for about 21.8% of the total, at $43.3 billion. — James Passeri

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Risk off (Finally): Investors Withdraw $1.5B from US Leveraged Loan Funds

loan fund flows
U.S. loan funds reported an outflow of $1.5 billion for the week ended Oct. 31, according to Lipper weekly reporters only. This marks the largest weekly outflow from loan funds since the week ended Dec. 16, 2015, which posted an outflow of about $2 billion.

This follows last week’s slight outflow of $7 million, and narrows the year-to-date total inflow to roughly $10.2 billion.

Mutual funds drove the bulk of the outflow this week, with an exit of $956 million, marking the largest exit from mutual funds since the week ended Dec. 23, 2015, which posted a mutual-fund exit of $1.2 billion (and barring a nominal $1.3 billion mutual-fund outflow for the week ended Nov. 11, 2017, which came as the result of a reclassification at a single institutional investor).

Meanwhile, ETFs reported an outflow of $551.5 million this week, indicating the largest weekly ETF exit on record.

The four-week trailing average snapped a 40-week streak in the black, slipping to negative $247 million, from positive $207 million last week.

The change due to market conditions this past week was a decrease of $10 million, following last week’s decline of $186 million.

Total assets were roughly $106.8 billion at the end of the observation period. ETFs represent about 11.7% of total assets, at roughly $12.5 billion. — James Passeri

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Free Event: Downstream Impact of Current Leveraged Loan Market Dynamics

A new, on-demand Webinar from LCD and S&P Global Market Intelligence is now available, examining the downstream impact of current U.S. leveraged loan market dynamics.

The free Webinar can be viewed here. All the slides used in the presentation are available for download.

This in-person event, conducted on Oct. 29, features a panel discussion moderated by LCD Sr. Editor Shivan Bhavnani, with

  • Andrew Bellis, Managing Director, Head of Liquid Loans at Partners Group
  • Pat Daugherty, President & Chief Investment Officer, Glacier Lake Capital
  • Mitchell Drucker, Managing Director at Garrison Investment Group
  • Randy Schwimmer, Senior Managing Director, Head of Origination & Capital Markets at Churchill Asset Management

Panel topics:

– Covenant erosion
– Unrestricted versus restricted subsidiaries
– Portability: What is it, and why are people talking about it?
– What will recovery rates look like after the next downturn?
– How does the current market (peak?) stack up vs 2007/08?
– What will the market see in 2019?

subordinated debt cushion

Also in this Webinar:

  • LCD Managing Director Ruth Yang provides a detailed look at credit risk, loan market recoveries, and the (considerable) value of a debt cushion.
  • Andrew Watt, Managing Director, S&P Global Ratings, focuses on that state of today’s credit market, and whether there are warning signals that the cycle is ending.
  • LCD Managing Editor Tim Cross presents an overview of today’s U.S. leveraged loan market, focusing on recent big-ticket LBOs, leverage, and issuance.

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Leveraged Loan ‘Weakest Links” Ranks Grow as Credit Quality Remains in Spotlight

LCD’s Weakest Links analysis for the U.S. leveraged loan market continues to highlight a strong undercurrent of risk.

During the third quarter of 2018, the share of loan Weakest Links was unchanged from the second quarter, at 7.2%. But the absolute number of issuers making up the Weakest Links rose from 87 to 93 during the third quarter. LCD’s loan Weakest Links are issuers in the institutional loan market with a corporate credit rating of B– or lower and a negative outlook.

The third-quarter count is the highest since LCD began tracking the number in 2013. Since that time the count has more than tripled, from 28 to the current 93.

An increase in Weakest Links can be an indicator of financial distress down the road, as the default rate on these issues remains sharply higher than credits not in the Weakest Links grouping. In the first three quarters of 2018, 11% of the credits from the 2017 year-end loan Weakest Links cohort have restructured, including the defaults of retailers Nine West and Sears, as well as Oil & Gas issuers Fieldwood EnergyPhiladelphia Energy, and Harvey Gulf. Looking back further to the Weakest Links from 2013, 32% have defaulted or restructured through the third quarter of 2018.

In contrast, 0% of the credits rated B or higher at the end of 2017 have defaulted or restructured, and just 6% in total of that pool at year end 2013 had done so in through today. – Ruth Yang

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Leveraged Loans: Single-B Share of Market Soars to Record High

b rated leveraged loans

 

There’s been much talk in today’s U.S. leveraged loan market about how borrower-friendly deal structures and creative accounting by issuers are introducing increased levels of risk.

While that might be the case – loan market pros debate to what level credit is deteriorating – one metric is clear: There are more lower-rated borrowers in market now than at any time ever, including the height of the last credit cycle, in 2007-08.

Specifically, so far in 2018, 59% of outstanding leveraged loans are from issuers rated B+ or lower, according to the S&P/LSTA Loan Index. That’s up from 55% in 2017 and from just 37% in 2008, before the onset of the Financial Crisis.

With U.S. leveraged loan outstandings at $1.01 trillion at the end of September, that means the B+ or lower share of the asset class stands at roughly $600 billion. – Staff reports

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Leverage Creep: With EBITDA Adjustments/Synergies, Risky Loans Grow Riskier

synergies 7x loans

EBITDA adjustments, or add-backs, have been a hot topic in the global leveraged loan and high yield bond markets over the past few years as private equity shops undertaking large M&A deals increasingly rely on this technique for financing.

Of course, these adjustments – where a PE shop or acquiring entity can add an expense back to profits, significantly improving a transaction’s pro forma numbers – are not without controversy. Debt investors complain vociferously that, via add-backs, actual risk is being masked, as borrower leverage down the road will be understated if the rosy earnings numbers detailed now don’t actually come to pass.

The largest portion of these add-backs comprises synergies, or the potential financial costs savings of combining two companies.

But just how much risk do these adjustments/synergies add? If a transaction’s debt/EBITDA ratio has crept higher based on adjusted EBITDA alone, how much riskier are these deals if EBITDA adjustments are stripped out?

A significant amount, apparently, when looking at the more aggressive deals in market, and when considering synergies. For example, a relatively slim 8% of U.S. leveraged loans backing M&A had pro forma debt/EBITDA of 7x or higher this year, including synergies, up from 5% last year and on par with 2014. While this metric has risen in recent years, it remains far below the 2007 record of 17%.

Assuming, however, that expected synergies are not achieved, the share of M&A transactions levered at 7x or higher jumps to 17% this year, up from 14% in 2017 and just a few percentage points below the 2007 record of 19%. – Marina Lukatsky

This story is part of a longer piece of analysis, available to LCD News subscribers, from LCD that details add-backs/EBITDA adjustments in detail.

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LCD comps is an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.