The money is pouring in,” says a somewhat awed Anthony Malloy, a portfolio manager at New York Life Investment Management who has seen the assets of his leveraged-loan portfolios swell from slightly more than $2 billion to $3.5 billion in the 12 months through mid-July. Credit the ubiquitous search for yield: Malloy’s portfolio of non-investment-grade bank loans is catnip to investors looking to lock in relatively high yields.
Loans to U.S. and European corporate borrowers rated double-B and B are issued and traded at a premium -- now typically 200 to 260 basis points -- to LIBOR, recently at 3.6 percent. With short-term rates rising and long-term U.S. Treasuries struggling to maintain an attractive yield advantage, returns of up to 6 percent (before investment management fees) are, not surprisingly, a magnet for institutional money. The global market for newly issued leveraged loans swelled from $167 billion in the first half of 2004 to $217 billion in the first six months of this year, according to Standard & Poor’s. (The U.S. accounts for $149 billion of the total and Europe for almost all of the remainder.)
Yield isn’t the whole story. Bank loans represent senior secured debt, meaning that leveraged-loan holders get first crack at assets should an issuer fail. Recovery rates, which have been running about 35 to 40 percent for holders of junk bonds, are better than 80 percent for leveraged-loan holders, according to Thomas Finke, co-head of the bank loan team at Boston-based Babson Capital Management.
As floating-rate credits pegged to LIBOR, leveraged loans also offer protection against rising interest rates. They tend to be less volatile in price than high-yield bonds, notes C. Richard Beard, a managing partner with Cardinal Investment Advisors in Clayton, Missouri. Still, the bank loans are usually callable when companies refinance, which limits their upside potential. “Prices barely get much above par,” says Steven Miller, managing director of S&P’s Leveraged Commentary and Data, a research service.
Investors in leveraged loans naturally worry most about credit risk. At the moment, with businesses generally in a positive phase of the credit cycle, the risk seems modest.
Defaults, which peaked at an annualized 8.2 percent rate in December, 2000, stood at just 1.3 percent for the 12 months ended June 30, 2005, notes Miller.
Nevertheless, given the capital rush into the asset class, some believe that risk is rising. Miller sees some cause for concern in borrowers’ “rising leverage multiples” -- higher debt-to-cash-flow ratios. “We’re starting to see the quality of the issuers diminish,” says Michael Bacevich, who manages $1.8 billion in leveraged loans at Hartford Investment Management Co. Leverage among corporate borrowers has swelled as a result of new waves of merger and leveraged-buyout activity, Bacevich explains, and loan investors will eventually foot the bill. “It will come home to roost in the form of higher default rates in the next two years,” he warns.
That’s one reason portfolio managers cite credit risk analysis as their primary focus. “Our style is focused on loss avoidance,” says Bacevich, noting that historically, “12 percent of all B issuers default within two years.” For the past couple of years, Bacevich has avoided both the auto manufacturers and their suppliers.
“The core of our business is performing fundamental credit analysis,” confirms Babson Capital’s Finke. Though loan investors are privy to the credit reports issued by bank lenders, Babson tries to go further. “We’re doing credit analysis to see if we agree with the banks,” Finke explains.
On occasion, credit analysis will unearth a worthy investment in an apparent heap of junk. As overbuilding telecommunications companies flooded the market with debt three years ago, Babson zeroed in on Nextel loans -- which were then deeply discounted along with other telecom debt. Reasoning that Nextel had been dragged down by its peers and confident the telecom company could pay off its loans, Finke bought deeply discounted Nextel debt in 2002. It was eventually paid off without default.
At NYLIM, Malloy looks for companies with predictable revenue and cash flow. These are especially important at a time when many companies are taking on added debt in LBOs or to fund acquisitions.
Case in point: Constellation Brands, a Fairport, New Yorkbased liquor manufacturer and distributor whose debt Malloy has been buying. “They’ve used leverage to finance acquisitions,” he says. “But we view the risk of default as low.” And as the holder of secured loans, NYLIM would be protected even in the event of default. “The asset value of the company exceeds the amount of secured debt,” Malloy explains.
Though most portfolio managers stress credit analysis, they differ widely on how much credit risk they’re willing to shoulder. At Boston-based Eaton Vance, which manages $19 billion in retail and institutional loan investments, Scott Page views high yields as a dangerous temptation. “We don’t stretch on yield,” says Page, who is co-head of the Eaton Vance bank loan team. “The risk involved in credit increases exponentially as you go down in credit quality.”
Page recently passed up a senior secured credit to Virgin Mobile USA, a wireless services provider launched by Richard Branson’s Virgin Group and Sprint. Eaton Vance concluded that Virgin Mobile was likely to break even, at best, in 2005 cash flow, yet was taking on debt to pay nearly $400 million in dividends. Says Page, “They were taking several hundred million dollars out to give back to Branson and Sprint.” The portfolio manager ultimately resisted the lure of a better-than-6 percent return. (Virgin Mobile declines to comment.)
At Dallas-based Highland Capital Management, chief investment officer Mark Okada is confident he can handle today’s higher levels of risk. Highland, which manages more than $14 billion in loans, leverages its size to invest heavily in research, according to Okada. With 48 credit analysts and portfolio managers, Okada believes he can anticipate trouble and sell before a high-yield issue begins to flounder.
“The manager’s task is to figure out which names will trade down and how to sell them before that happens,” Okada says. “We believe alpha is a function of what you sell and not what you buy.”
Highland was one of the first to spot looming troubles for Atkins Nutritionals, the Ronkonkoma, New Yorkbased low-carbohydrate-diet company. Highland had positions in two Atkins loans and sold out in the first quarter of 2004 at an average price just above par. Recently, in the wake of Atkins’s August 1 bankruptcy filing, one loan was trading at 70 cents on the dollar and the other at 10 to 15 cents on the dollar.
How did Highland know to bail? Okada acted on the research of a credit analyst devoted exclusively to the food industry, who concluded that Atkins would have trouble holding on to market share as other food companies brought low-carb products to market.
Recently, as the rush of capital into leveraged loans has begun to compress spreads on both high- and low-risk issues, in the U.S. especially, some managers wonder whether the asset class is still attractive. “When I see spreads breaking below 200 basis points for weak double-Bs, I have to ask myself, ‘Why am I in this market?’” muses Ray Kennedy, who is, in fact, in the market in a big way. As head of global high yield for Pacific Investment Management Co., Kennedy oversees $31 billion in assets, including $7 billion in U.S. and European loans.
“We’re out there comparing U.S. leveraged-loan offerings with what’s available in Europe and in high-yield bonds,” says Kennedy. With strong demand pushing down credit spreads on U.S. loan offerings, Europe is now more attractive than the U.S., he believes.
In the U.S., Kennedy observes, banks have loosened some loan covenants, easing up, for example, on tests of whether companies can pay future dividends. European lending standards are tougher.
That’s one reason Kennedy recently bought loans of Telenet, a European cable company. The notes offered a 250-basis-point credit spread. He likes the predictable revenue flow of cable and cites Telenet’s relatively low debt level: about two times earnings before interest, taxes, dividends and amortization. “In the U.S. a two-times-debt/ebitda loan would be about LIBOR plus 200,” notes Kennedy, savoring the superior Continental spread.
