Generals fight the last war and so do regulators, but there are instances when measures taken to shore up after one crisis work well in the next. Following the Lehman Brothers collapse in 2008 capital reserve requirements for banks became more stringent and when Covid hit the Basel III protocol was a reasonably effective Maginot Line.
Colossal intervention by central banks and governments is why the financial system didn’t melt down in 2020, but better capitalised banks and circumspect risk management helped ensure the patient was in good state to respond to the medicine. Prudency in lending and corporate finance culture has also played a role in the health of bond markets, at least in terms of borrowers’ solvency.
Anecdotally, fixed income professionals like Walter Kilcullen at Western Asset (which manages $491bn) rate the stock of debt as some of the “best quality [I’ve seen] in my career”. But now the dynamics of the corporate bond market are looking tricky.
Default risk had been thought to be well contained (Western Asset says cash flow coverage of payment obligations is 3.6 times for the market versus below 2 times pre-2008) but high-yield bonds have sold off to an extent on fears of the new Omicron coronavirus variant. Yet even after such a readjustment, the valuations of bonds make it possible that sensitivity to other risks than default will be heightened.
Adding to the complexity, the fixed income sub-asset class that’s providing part of the answer in a new hunt for yield raises the spectre of collateralised loan securities that blew up in the past.
Collateralised debt and shadow banking: have we been here before?
Leveraged loans are so-called because they are typically extended to companies that already have a high quantity of debt or a poor credit history. The attraction to borrowers over the last few years has been that, unlike bonds, the loans are usually prepayable without penalty. Furthermore, the maintenance covenants are less stringent, making loans increasingly desirable as a financing instrument by issuers of less than investment grade debt.
Many loans pay a floating rate of interest and offer a spread over Libor (the interbank lending rate being replaced by Sonia) to compensate for a higher default risk. The market for this debt is booming, having grown from $800bn in 2014 to $1.4tn now, with around 70 per cent of the loans being bought by collateralised loan obligations (CLOs).
Unlike bonds, loans aren’t directly tradeable on the secondary market, but a group of them can be bought and securitised. The CLOs are packaging loans from a variety of corporate issuers creating an investable asset class that is highly cash generative. Although credit quality is good by historic standards (the last 12-month default rate is one1per cent versus a longer run average of 3 per cent), there are obvious risks.
The practice of securitising various forms of loans has a long and sometimes chequered history. Most famously, mortgage loans were packaged into collateralised mortgage obligations (CMOs) and the global financial crisis of 2007/09 started when many of those underlying loans went bad.
That cataclysmic turn of events is still felt now, and its legacy is seen in the financial policy response to Covid. Another impact was the need to supervise banks and be more proscriptive about the size of their balance sheets.
Greater prudential regulation has arguably been a big reason banks have (with support) functioned well in the pandemic, but a knock-on effect has been the treatment of leveraged loans the CLOs buy. Loans are assets on a bank’s balance sheet, but as loans can go bad and cause solvency issues, regulators want these assets to be held in a sensible ratio to the safer equity parts of banks' capital funding.
Writing loans is how banks make a large part of their money, so limits are bad for business. It’s also bad for the economy as companies find it harder to access the funding and liquidity they need to function and grow. The workaround has been for banks to originate loans but rather than hold them on balance sheets and make money from the interest, they sell the loans to CLOs for a profit. The CLOs then own the asset, receive the interest on it but have the risk of the borrower defaulting.
The crucial difference to the systemic risk that was allowed to build up ahead of the global financial crisis is that back in the 2000s the banks were buying CMOs off one another, as well as originating the mortgages the products were built on. Both types of asset contributed to the bloated balance sheets that eventually unwound so dramatically.
Where there may be more questions on the significance of CLOs, is that it inherently seems like a form of shadow banking. That is to say a large amount of financing that exists in the economy with the ownership of the debt assets (loans) lacking transparency and therefore being a source of systemic risk.
Proponents of CLOs like Tom Shandell, CEO of Marble Point Credit Management, may beg to differ. In Shandell's opinion: “While it may be convenient to call this shadow banking since the ultimate investors in leveraged loans are not banks, leveraged loans are for the most part originated by banks regulated by the Federal [United States] government and therefore should not be considered shadow banking.”
That’s not an unbiased view but the fact these loans have oversight at origin is an important distinction. In any case, new sources of financing are not being dismissed out of hand these days, even by regulatory bodies. For example, a cursory browse of the Financial Conduct Authority (FCA) website, brings up a 2017 speech by Peter Andrews (the FCA’s former chief economist and now a senior adviser at Oxera consultancy), acknowledging that there could be benefits to forms of shadow banking like market-based finance.
Tight credit spreads make loans attractive to fixed income investors
Loans have become more attractive to investors thanks to the expensiveness of debt securities. The valuation of corporate bonds tends to be expressed in terms of the spread between their yields and those of 'risk-free' (at least when it comes to default) quality government bonds.
Corporate bonds where the likelihood of default is considered very low are considered investment grade (IG) and are priced at much tighter spreads to sovereign yields. Lower-rated debt issuers have wider spreads to government bonds and are referred to as High-Yield (HY) credit.
Government bonds are hugely expensive right now thanks to low interest rates and central bank asset purchase programmes (quantitative easing). Some IG corporates have been purchased, too, which along with the effect of investors having moved along the risk spectrum when sovereign yields fell has pulled IG and HY yields down.
When there is spread compression to government bond yields caution is necessary. It reflects market confidence in the quality of corporates but the emergence of the Omicron variant of coronavirus is a reminder the outlook for companies can sour significantly. Any adjustment in the risk premium will be felt keenly by investors from a position of high valuation.
Furthermore, even if fears of a new wave of lockdowns aren’t realised, there is very little wriggle room for yields to absorb other forms of risk than default. Inflation and interest rate risks are worrisome as they will cause fluctuation in yields.
Bonds pay fixed coupons, so for yields to rise the market price of bonds already issued must fall; this means there is a chance of capital losses. Inflation causes bond prices to fall because investors demand a higher nominal yield, so the real value of cash flows isn’t diminished. Another closely linked risk, is when central banks raise interest rates to combat inflation: raising the floor on risk-free rates pushes up yields on all bonds.
When spreads aren’t tight to begin with, there is more leeway to absorb some of the rise when the market is pricing the effect of inflation or interest rate rises. This makes sense given the normal reason for these factors is the economy strengthening. Typically, corporate bond default risk is falling at the same time, so the overall spread to government bonds shouldn’t change by as much as the rise in risk-free yields.
That’s not the dynamic right now and investors are looking at alternatives such as CLOs when it comes to the high-yield end of the quality spectrum. Western Asset’s Ryan Kohan points out that “bank loans have done well in rising rate environments in the past”. The limited duration of the loans (duration is effectively a measure of price sensitivity to changes in yields) means they are less vulnerable to rates, so if the credit quality is good then wider spreads for leveraged loans compared with high-yield credit is attractive.
A fourth risk to be considered, with central banks set to retreat from asset purchases, is liquidity in capital markets. That said, actions that seemed certain a week ago could be reappraised in light of the new coronavirus variant. Bond investors like Western Asset were optimistic as the reinvestment of coupons by central banks means tapering isn’t a total exit by the guaranteed central bank buyers, plus they reckoned that an improving economic situation could mean capital gains as some credit re-rated to higher grade.
Omicron may delay tapering but a boost to the outlook for economies and therefore debt upgrades would also be on hold. High-yielding options like leveraged loans could still pay off, but as the latest Covid uncertainty reminds us, the wider risk premiums here exist for a reason.
