Many of you would, we hope, have been reading the Market Commentary since 2004 when we began to send it out every Friday. The intention was to draw the readers’ attention to often arcane and under-reported areas of financial markets, on which it would hopefully inform and illuminate. After speaking to some of our customers, we believe that it will be better to circulate the Market Commentary using more modern media. Therefore, starting in early November, we will be e-mailing a twice monthly video release. The intention remains to provide informative and market relevant commentary from a wide rota of Whitefoord investment partners and staff. You will be able to put faces to names and see the wide range of skills and views from which we hone our overall Strategies. Do let us have any feedback by contacting your Account Manager or any of the Investment Team who present the videos.
It is very rare for the Federal Reserve (the Fed) to mention concern over a particular segment of the market, but it did last week in its released minutes from the September interest rate setting meeting. ‘Some participants commented about the continued growth in leveraged loans, the loosening of terms and standard of these loans, or the growth of this activity in the non-bank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability.’ This is Fed Speak for “mind your eye”. In other words: do not be complacent about the impact of our rate raising policy. This echoed the comments of the Bank Of England last week.
As the Fed raised rates in September and gives the impression that it will move again in December and during 2019, it is no surprise that both the two-year Treasury yield and three-month Libor rose to fresh cycle highs earlier this week of 2.90% and 2.47% respectively, up from 0.48% and 0.26% as recently as 2015. Such a big rise in bond yields for short maturity duration instruments has helped tip the investment scales towards floating-rate leveraged loans at the expense of conventional, fixed rate high-yield bonds. The performance figures are stark. Year-to-date earlier this week, the S&P/LSTA Leveraged Loan Index is up by 4.3%, which is greater than the 1.65% return generated by the Bloomberg Barclays US Corporate High Yield Index. Even more starkly, the gap between the lowest-rated leveraged loans (a polite phrase for what was previously described as junk) and high yield bonds is even wider; an index measure calculated by J.P. Morgan is up 11.58% year-to-date and this is almost double the 5.93% advance in the Bloomberg Barclays Capital Caa US High Yield Total Return Index. This is just the sort of stuff some portfolio managers have been using to pack out supposedly balanced portfolios with moderate equity content, when in reality these instruments are equities in drag. Shades of 2007/2008? We are at the tail end of a ten year period of rampant risk takers being rewarded.
Credit investors have certainly noticed. This past week, Bloomberg reported that the total volume of outstanding leveraged loans overtook high yield for the first time making leveraged loans ‘the go-to financing source for speculative-grade companies.’ Indeed, assets under management at US loan funds reached a record $184billion in September, according to Thomson Reuters, up from just over $100billion in February 2016. It is not just institutions joining the fray, as retail inflows into leveraged loan funds are also up for the ninth straight month. The proliferation of leveraged loans has caught the attention of the former Fed Chair Janet Yellen and the Bank of England. Yellen suggested ‘regulators should sound the alarm.’ The Bank of England’s Financial Policy Committee meeting featured a similar warning, pointing to the ‘risk that true leverage multiples were being under-reported (and) if borrowers in leveraged loan markets inflated their earnings in leverage calculations, for example by assuming future efficiency gains.’ Sure enough, a recent analysis by S&P Global Ratings of corporate M&A deals from 2015 found that such hypothetical, future “add-backs” represented a rising proportion of earnings. If the rising rate cycle bursts this bubble then investors in the space will be nursing some painful losses.