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Nov. 14, 2019, 7:31 a.m. EST

Bargains in the $1.1 trillion leveraged loan market aren’t big enough yet for largest investors

CLO funds are buyers of about 70% of the market, but are waiting for even cheaper prices

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By Joy Wiltermuth and Sunny Oh


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Stress in the $1.1 trillion leveraged loan market this year has pulled down the prices of the debt of weaker companies, but not by enough yet to generate bargains for sector’s largest investors.

Retail investors have sold and credit rating agencies have accelerated downgrades, leaving stacks of loans trading at distressed prices. Yet managers who pool leveraged loans into specialized funds called collateralized loan obligations, or CLOs, have remained hesitant to add the most beaten down borrowers to the pools.

“I do feel there are some bargains, due to lower corporate earnings or ratings downgrades,” said Leland Hart, head of U.S. loans and high-yield at Alcentra, in an interview with MarketWatch. “But I don’t see people barreling into them today.”

Prior to joining Alcentra in January 2018, Hart spent nearly a decade at BlackRock Asset Management as its head of loans, CLOs and infrastructure debt.

And while some see a pile of tinder in the U.S. corporate debt boom that could amplify pain in a recession, Hart said CLOs are unlikely to provide the spark.

“You don’t have that red panic button that you might have in a daily liquidity ‘40 Act fund,” he said of CLOs and the recent scrutiny of industry limits around Triple-C rated loan holdings. A ‘40 Act fund refers to investment vehicles sold to retail and institutional investors through public markets, as opposed to privately-offered funds.

“It may impact the timing of equity payments,” Hart said of Triple-Cs that exceed the standard limit of about 7.5% of a fund’s entire holdings. “But you never need to sell. That’s probably the biggest virtue of a CLO. You can sell today if you think something will be worth less tomorrow, but you are never a forced seller.”

Meanwhile, credit rating downgrades of U.S. corporate loans considered “highly speculative” have accelerated this year, swelling the ranks of loans rated B- or lower to a near 20% share of the market, or the most since 2009 when it shot up to 30%, according to Goldman Sachs.

This Goldman chart underscores the rising ranks of U.S. corporate loans rated B- or lower.


Goldman Sachs

Such debt is drawing particular scrutiny amid fears that it could be downgraded and then dumped by CLOs, which represented around 70% of demand for leveraged loans in 2019, according to a recent analysis from S&P Global Market Intelligence’s LCD platform.

Although CLOs are designed to provide a hedge against plummeting loan prices, their managers aren’t yet increasing support for the sector’s weakest performers, which could leave riskier loans vulnerable to going even lower in price.

“People have always made the argument that CLO managers can swoop in and take advantage,” said Lale Topcuoglu, a senior fund manager and head of credit at J O Hambro Capital Management, in an interview. “Maybe a few in the market are doing it, but you’re not seeing it.”

Managers of CLOs buy pools of loans and slice them into top, Triple A-rated securities and sub-investment grade ones that offer yields that correspond to their likely odds of saddling investors with losses. To get that yield, bond investors ask for a spread level, or compensation over a risk-free benchmark, that can offset their risk of owning an investment that could sour.

CLOs also rely on “equity” financing, which is first in line to see payment shortfalls. This can happen if a fund’s performance wanes, or if holdings of CCC-rated loans mushroom and trigger a diversion of fund payouts to senior bondholders.

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