Updated Thursday, April 24, 2014 as of 9:26 PM ET
Portfolio - Fixed Income
Junk Loans Top ’08 Record as Safeguards Stripped: Credit Markets
Monday, December 23, 2013

(Bloomberg) -- The amount of loans to the riskiest U.S. companies ballooned to a record this year, propelled by unprecedented demand for floating-rate debt that offers protection from rising interest rates.

The market for junk-rated loans increased to $683 billion, exceeding the 2008 peak of $596 billion, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data. The $130 billion surge this year was fueled by borrowings that don’t include typical lender protections such as limits on leverage.

Loans, which suffered the biggest losses in the fixed- income market during the financial crisis, staged a comeback as investors funneled a record $64.4 billion into funds that buy the debt in anticipation the Federal Reserve would start unwinding its bond buying that’s suppressed borrowing costs. The demand has enabled companies take on more debt for shareholder rewards, prompting regulators to warn that the excesses which contributed to the credit crisis may be creeping back.

“The worst deals are made in the best of times is a phrase we hear often,” Frank Ossino, a money manager in Hartford, Connecticut, who oversees $2.5 billion of loans at Newfleet Asset Management LLC, said in a telephone interview. “While the default environment will remain low, ever more aggressive transactions become the seeds of the next default cycle.”

Companies from personal-computer maker Dell Inc. to Hilton Worldwide Holdings Inc., the world’s biggest hotel chain, obtained $282 billion of loans that were covenant-light, meaning they didn’t include financial maintenance requirements, according to data compiled by Bloomberg.

Riskier Deals

Speculative-grade companies also stepped up borrowings to pay their owners dividends, with issuance of such debt reaching a record $63 billion this year, Bloomberg data show. Dividend deals, rather than refinancing debt at lower interest rates or funding expansion, do little more than add leverage.

These risky borrowings have been supported by record flows into loan funds, whose assets grew by 85% in 2013, according to a Dec. 19 report from Bank of America Corp.

While increasing investments into loan funds enhances liquidity and increases transparency, the ability of individuals to withdraw money on a daily basis increases the risks of deeper selloffs because “there’s less sticky money in the system,” Ossino said.

Worst Performer

In 2008, when the global economy was in the throes of the biggest financial crisis since the Great Depression, loans in the U.S. tumbled 21% in the fourth quarter of 2008, compared with a drop of 18% for junk-rated bonds, according to the S&P/LSTA Leveraged Loan Total Returns Index and the Bank of America Merrill Lynch U.S. High Yield Index. Investment-grade debt gained 1.6%.

The growth in junk loans has led regulators to warn about deteriorating underwriting practices.

The Fed and the Office of the Comptroller of the Currency sent letters to some of the biggest banks in recent months asking them to avoid originating loans that can be considered “criticized,” or debt seen as having some deficiency that may result in a loss. The regulators identified 42% of leveragedloans in that category this year in communications sent as recently as October.

Leveraged loans and high-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.

The average yield to maturity on new-issue first lien loans fell to 4.69% at the end of last month from 5.82% at the start of the year, S&P LCD data show.

2014 Forecast

Citigroup Inc. is forecasting U.S. companies will issue $375 billion of new loans next year, 15% less than what they raised in 2013, mainly because of the potential impact of regulations on collateralized loan obligations.

“While the eventual form of regulations is still unclear, its effect on leveraged loans will be greater than high-yield,” analysts led by Michael Anderson wrote in a Dec. 17 report.

Regulators are considering rules targeting CLOs, the biggest buyers of loans, as part of the financial reform mandated by the Dodd-Frank Act, that may force banks to hold onto portions of debt they sell to CLOs.

CLOs raised more than $76 billion this year, the most since 2007, according to Citigroup.

Implementation of these rules may reduce CLO formation by as much as $250 billion, according to a study published Dec. 18 by the Loan Syndications and Trading Association.

Even as loans receive greater scrutiny, firms such as Citigroup predict they will generate gains for investors.

‘Reasonable’ Income

Citigroup is forecasting leveraged loans to return 3% next year compared with 2.5% forjunk bonds. Loans are poised to return 5% this year, after gaining 10.51% last year, according to the S&P LSTA Leveraged Loan 100 index.

Get access to this article and thousands more...

All Financial Planning articles are archived after 7 days. REGISTER NOW for unlimited access to all recently archived articles, as well as thousands of searchable stories. Registered Members also gain access to exclusive industry white paper downloads, web seminars, blog discussions, the iPad App, CE Exams, and conference discounts. Qualified members may also choose to receive our free monthly magazine and any of our daily or weekly e-newsletters covering the latest breaking news, opinions from industry leaders, developing trends and growth strategies.

Already Registered?

Advisors on the Move: Cambridge Snags $500 Million Team

Current Issue

The April Issue is now online!

Already a subscriber? Log in here