Demand for bank loans continues amid expectations for rising interest rates in 2018. Given the floating rate nature of the asset class, we are positive on bank loans relative to most other fixed income asset classes. In addition, a favorable economic backdrop combined with default rate forecasts around historical averages of about 2-3% further support an optimistic outlook. However, technical risks remain the largest concern. Increased demand for bank loans has the potential to affect long-term returns. Loans don't feature call protection like high yield bonds, meaning the issuer can cut their loan spread after a short time—typically six months—if there is enough demand by investors to support such "re-pricing" events. We have also seen excess demand lead to more aggressive underwriting practices and weakened deal structures, as managers must go somewhere with their cash and are willing to accept a lower return for equal or greater risk to stay fully invested. In this environment, we believe it is critical to remain focused on security selection and risk management.
The supply-demand imbalance
Over the past year, the steady demand for banks loans has created a modest supply-demand imbalance that has favored the issuers. There has been a strong bid for banks loans with the majority of the demand coming from collateralized loan obligation (CLO) managers. New issuance, although strong by historical standards, couldn't keep pace with the demand from CLO managers and retail inflows in certain months. The result was an aggressively priced market environment marked by mounting leverage, deteriorating credit quality and covenant-lite deals.
As we continue through 2018, the poor market technicals have abated somewhat, as supply has been stronger than expected. Exhibit 1 illustrates the supply-demand imbalance over the last year. However, we are still cautious that this imbalance will return if the primary market can't keep up in the back half of 2018. Demand will likely continue in the form of ongoing CLO issuance and retail inflows if the Federal Reserve's forecast for future rate increases stays true.
Exhibit 1: Institutional market supply-demand balance
Source: LCD, an offering of S&P Global Market Intelligence. As of June 7, 2018. Used with permission. Based on (a) new issuance minus repayments minus (b) CLO issuance and Prime Fund inflows.
Aggressive underwriting activity
Amid the high demand for bank loans, not only have spreads tightened, but newly issued structures have been deteriorating. First, aggregate credit quality has declined. The market is seeing incremental issuance at the B-rated level rather than BB-rated (Exhibit 2).
Exhibit 2: Lower-quality, B-rated issuance is on the rise, total leveraged loan volume by S&P rating
Source: S&P Global Market Intelligence. As of Q1 2018. Used with permission.
Second, leverage has gradually increased and is approaching pre-financial crisis levels and higher at the first lien level. The average first lien debt-to-EBITDA ratio has weakened from approximately 3x pre-crisis to above 4x. The offset to higher leverage has been stronger cash flow coverage given the low interest rate environment and higher equity contributions from the private equity community. According to S&P Global Market Intelligence, the average new LBO in first quarter 2018 featured first lien leverage roughly half a turn above pre-crisis levels.
Exhibit 3: Average debt multiples of large corporate LBO loans
Issuers with EBITDA of more than $50M.
Source: S&P Global Market Intelligence. As of Q1 2018. Used with permission. Media and telecom loans excluded prior to 2011. EBITDA adjusted for prospective cost savings or synergies.
Exhibit 4: US LBO purchase price multiples
Source: LCD, an offering of S&P Global Market Intelligence. As of April 26, 2018. Used with permission.
Exhibit 5: EBITDA adjustments are more common
Share of sponsored transactions with pro forma EBITDA adjustments.
Source: LCD, an offering of S&P Global Market Intelligence. As of May 17, 2018. Used with permission.
Third, loan covenants have weakened since the financial crisis. Borrowers are able, amid strong demand, to offer investors less protection via covenants. Now, over 75% of deals lack a maintenance covenant, a feature that affords investors greater influence on company actions if the credit becomes weak and the possibility to receive amendment fees and/or a higher coupon upon covenant breach. Other features, such as debt incurrence tests, guarantor packages, restricted payment baskets, looser EBITDA definition and allowed addbacks, have also shifted in favor of the borrower.
Ultimately, a weakening credit quality profile poses concerns about future defaults and subsequent recoveries. In the event there's a shock to the system over the next two to three years, defaults may increase. Given the lack of covenants, as well as the higher amounts of leverage, it's quite possible the market will witness a decline in the associated recoveries. While historical recoveries for first lien loans have averaged about 70 cents on the dollar, depending on the sector, we expect to see loan recoveries in the low-60s in the next default cycle.
While broad market tailwinds, such as rising rates and an improving consumer, are supportive of the bank loan market, we remain concerned about mounting leverage and increasing risks. A focus on the current stage of the credit cycle is critical, as is to approach new deals with caution. With these areas of concern in mind, we maintain a constructive view on bank loans relative to other fixed income sectors.
Our disciplined investment approach
We believe this environment highlights the importance of a prudent approach. Our focus is to remain true to our disciplined process and investment style by concentrating on fundamental research and downside risk management. A key consideration in the firm's process is to evaluate if the loan's expected return justifies the level of risk. In an effort to manage risk, portfolio managers partner with research analysts to analyze the credit in downside scenarios. When conducting loan research, our analysts heavily scrutinize the investment thesis, focusing on the quality of management, flexibility of the capital structure, credit agreement protections (or lack thereof), and the volatility of the business. We believe that a disciplined, research-driven approach to security selection is paramount in this environment and will continue to look for opportunities to add value.
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