Part 3: Masking Deterioration of the Underlying Collateral and Rearview Mirror Analysis

Daniel Zwirn, Jim Kyung-Soo Liew and Ahmad Ajakh | Published in The Journal of Fixed Income, Fall 2019

Masking Deterioration of the Underlying Collateral and Rearview Mirror Analysis

Today’s BBB corporate bond is yesterday’s BB. A metric that is important to consider is the rise of lesser quality bonds in the corporate bond market. An article in The Wall Street Journal recently pointed out the increase in BBB corporate bonds reaching record levels (Goldfarb 2018). Exhibit 2 shows that increase over time and compares it to other investment-grade bonds for reference.

As Exhibit 2 shows, there has been an alarming increase in the number of BBB bonds issued after 2014. It is important to note that pre-crisis levels of debt were less than $1 trillion. That figure more than doubled by 2018, to $2.3 trillion of BBB-rated corporate debt outstanding and has been rising at a faster rate. In 2007, less than 40 percent of Citigroup’s US Broad Investment-Grade Corporate Bond Index was rated BBB. Today, about 47 percent is classified as such (Grant 2018). In 2007, average daily trading volume for BBB bonds was $3.3 billion versus $1.5 billion for BB bonds; in Q1 2018 daily trading volume for BBB bonds rose to $12.7 billion versus $4.8 billion of BB bonds.6

Exhibit 2

Outstanding Debt—BBB versus Other Investment-Grade Bonds over Time

Exhibit02 - 2020-06-12Ax

The BBB market is not only more crowded, but, disconcertingly, it is also riskier (on a comparable basis) by virtue of having more leverage, as measured by debt divided by EBITDA. Exhibit 3 shows that, compared with leverage of 2.0´ during the 2008 financial crisis, average leverage has crept up markedly to 3.2´ for BBB credits (Racanelli 2018). Credit analysts at Morgan Stanley wrote that “If the companies in our universe were rated based on their leverage, we estimate that over a quarter of the investment-grade market would have a high-yield rating, using Moody’s leverage buckets across sectors” (Grant 2018). It is critical to highlight that some of the companies that have piled on debt to engage in mergers or acquisitions will easily free-fall into junk bond ratings when the next economic downturn comes. The relatively smaller high-yield market will have to absorb this new supply, leading to a sharp price drop. The present spreads do not adequately compensate investors for the risk they are taking.

Deterioration in middle-market corporate lending standards. Next, we pair the increasing trend of low-quality bonds with an increase in the level of leverage in middle-market companies. Middle-market companies are defined as companies with EBITDA of less than $50 million dollars. Exhibit 4 shows the evolution of leverage for middle-market companies.

The level of leverage is one of the most important gauges of credit risk, and it has increased consistently since 2010 for middle-market companies. That level is now higher than the level of leverage immediately preceding the financial crisis of 2008. The most reasonable explanation for the current high leverage level is the availability of easy money over the past decade. This was precisely the primary underlying cause of the 2008 financial crisis and should be a red flag going forward. In response to the high leverage concern in the wake of the 2008 financial crisis, the Federal Reserve imposed tighter regulations and reserve requirements on financial institutions with the aim of bringing about better leverage control. These more stringent regulations have shifted the same leverage risk to insurance companies and pensions by way of private fund offerings instead of their intended consequence of financial institutions becoming more self-disciplined and responsible with their use of leverage.

Exhibit 3

Leverage for Different Investment-Grade Bonds

Exhibit03 - 2020-06-12B

Exhibit 4

Leverage for Middle-Market Companies Measured by Total Debt/EBITDA

Exhibit04 - 2020-07-07

Along with rising leverage levels, the increase in direct private debt should also cause concerns about a developing bubble. For mid-size companies that are too small to enter the bond market but too big to simply rely on bank loans, private debt can be a good option. Private debt tracked by Preqin has increased four-fold over the last decade. Although there is a trend of decreasing returns, feedback shows that most investors think returns from private debt will meet or exceed their expectations.

However, attractive returns from private debt are fleeting because too many investors chasing yields have caused those yields to compress. When the next downturn comes, it will become clear that the low returns ultimately cannot compensate for the risks.

Similarly, there are an increasing number of investors in PE funds. Prequin (2018) showed that in 2018, Apollo IX completed fundraising of nearly $25 billion dollars, a record high level. Also, six well-known PE funds have recently closed or announced closures that combined, exceeded $100 billion in fundraising.7 Strong demand from investors leads to intense rivalry among fund managers. Consequently, some managers are paying 11–12 times EBITDA to secure deals, which is an even higher multiple than the previous peak in 2007. It is important to note that according to Warren Buffett, the long-term return for corporate equity risk is about 6 percent (Tully 2018). This environment of fierce competition makes it unlikely that PE funds will perform as strongly as they have in years prior. A principal at AQR, Antti Ilmanen, said, “Private equity doesn’t seem to offer as attractive an edge over public market counterparties as it did 15 or 20 years ago” (Ilmanen et al. 2019, 11). Analysts also warn that the PE industry may have reached a peak and caution that sustaining high performance in the coming years appears challenging. With so much money on the sidelines, one risk is that managers will end up overpaying for assets, thus reducing future returns. Exhibit 5 shows that the dry powder of PE totaled nearly $1 trillion by the end of 2017 (Espinoza 2018), meaning that more than 30 percent of the total AUM in PE funds was not invested.

Just because subprime auto loans “did well last time” doesn’t mean they are safe now. An example of a typical behavioral bias is overconfidence. This bias is exacerbated when it is supported by what has worked in the past. We use the auto loan market to illustrate this principle.

A colorful article on subprime auto loans that appeared in Zero Hedge in 2015 reported that the financial firm Skopos sold $154 million of asset-backed securities (ABS) in auto loans where 14 percent of the collateral pool of loans were from borrowers with no credit score. The rapid increase in the number of structured products sold to investors possessing a weak credit base ominously echoes the proliferation of similar structures that were packaged, sold, and backed by household borrowers for the NINJA loans that preceded the financial crisis of 2008: “NINJA” stood for no income, no job, or asset.

Exhibit 6 shows the growth of car loans. We can clearly see the growing trend, with car loans currently representing a total of $1.2 trillion of outstanding debt. From a behavioral perspective, we tend to think that because car loans were relatively safe during the financial crisis of 2008, they will be safe in future financial crises. Exhibit 7, however, shows that the delinquency rate of subprime auto loans has been steadily rising since 2011, reaching a historically high rate of 5.5 percent as of the beginning of 2019; prime auto loans maintained a delinquency rate lower than 0.5 percent over the same time period.

Subprime auto loans are tempting, providing easy access to credit for consumers who want to purchase status cars they cannot otherwise afford. This scenario is a clear harbinger of economic trouble for the sector. Additionally, when the economy takes a dip, many of these consumers will suddenly struggle to make car payments on a car they could barely afford to purchase even when the economy was strong. Investors would be wise to keep a vigilant eye on the auto loan markets: once this market descends into mass default, it is possible that those defaults will create a domino effect across the entire credit market.

Similar to the pattern of delinquency rates in the auto loan market, Exhibit 8 shows the delinquency rate of residential mortgages before and after the crisis. Two years prior to the financial crisis, the delinquency rate rapidly increased until it peaked in 2010; then it sharply dropped to its lowest point, where it stabilized at a level of 2–3 percent. The striking similarities between the delinquency rates of these two markets allows us to draw a supportable conclusion that a subprime auto loan bubble is developing and will likely traverse the same disastrous route as the subprime mortgage market in 2008.

Leveraged loan data. To put things in perspective, we now turn our attention to the leveraged loan market and compare it to the pre-crisis subprime mortgage market in 2006. This comparison is illustrative because a leveraged loan and a subprime mortgage share common features. A subprime mortgage is created for individuals with poor credit (a FICO score ranging between 500 to 600), in the same way that a leveraged loan is created for corporations with poor credit ratings.

According to the definition of S&P Leveraged Commentary & Data (LCD), a well-known provider of leveraged loan news and analytics, a leveraged loan is typically for borrowers with low credit ratings of BB– or lower, and additionally, any loan that has a borrowing rate of at least LIBOR plus 125 basis points and that has no current rating. Note that the definition of leveraged loans varies between different types of lenders.

Exhibit 5

Private Equity Assets Under Management

Exhibit05 - 2020-07-07A2

Exhibit 6

Motor Vehicle Loans Outstanding over Time

Exhibit06 - 2020-07-07

Exhibit 9 shows global leveraged loans compared to corporates as a share of total corporate credit in the United States, United Kingdom, and Eurozone, and the US subprime mortgage in 2006 as a percentage of the total US mortgage market. Exhibit 9 shows that the amount of leveraged loans has substantially increased over the past decade and now represents a significant 9 percent of the advanced economies’ credit to corporates.

Exhibits 10, 11, and 12 show the growth in leveraged loan issuance (Bloomberg 2019), where one can clearly distinguish an increase in the covenant-lite share of outstanding leveraged loans, and rising debt-to-EBITDA ratio, respectively, in the US since 2006.

Exhibit 7

Delinquency Index of US Auto Loans

Exhibit07 - 2020-06-12A

Exhibit 8

Delinquency Rate on US Residential Mortgages

Exhibit08 - 2020-06-22

In addition, more companies are increasingly relying on newly issued leveraged loans for refinancing. If an economic downturn occurs and defaults start to pick up, demand would dry up, leaving companies with nowhere to go for refinancing, triggering even more defaults.

Exhibit 9

US Subprime % versus Global Leveraged Loans %

Exhibit09 - 2020-06-22B

Exhibit 10

US Leveraged Loans Outstanding

Exhibit10 - 2020-06-22

It is reasonable to think of pre-crisis subprime mortgages as leveraged loans because the customers for both are weak borrowers with poor to no credit ratings. In too many instances, the borrowers of subprime mortgages are not required to make down payments, nor to show evidence of employment or consistent income.

In that sense, a subprime loan is a leveraged loan by any definition of leverage. This comparison naturally leads to the observation that BBB-rated bonds show similar patterns as the mortgage market did before the credit crisis. As is the case for the high level of leverage in mid-market companies, the greatest danger that leverage poses is its ability to amplify otherwise small levels of uneasiness in the system, which can trigger a systemic shock. This has happened in the subprime market in the past and it can happen in the corporate credit market now. With economic downturns occurring on a dependable cycle, it is only a matter of time before we witness—and suffer—the consequences of an over-leveraged credit market implosion.

Exhibit 11

Covenant-Lite Share of Leveraged Loans Outstanding

Exhibit11 - 2020-06-22A

Exhibit 12

Average Debt-to-EBITDA Ratio for Newly Issued Leveraged Loans

Exhibit12 - 2020-06-22B

Rearview mirror analysis of CLOs. Collateralized loan obligations (CLOs) are investment vehicles that buy pools of floating-rate leveraged loans from banks and then package those loans into tranches of debt with credit ratings ranging from AAA to BB, as well as one tranche of equity. Exhibit 13 shows a typical capital structure for a CLO, and distinguishes the various tranches and their respective ratings from rating agencies (Guggenheim 2017).

Exhibit 13

CLO Capital Structure

Exhibit13 - 2020-06-23

Issuance of CLOs hit a record high of $125 billion in 2018 as investors sought a floating-rate product in the rising interest rate environment, as shown in Exhibit 14. Meanwhile, as illustrated in Exhibit 15, CLOs outstanding as a subset of collateralized debt obligations (CDOs)8 have risen significantly, from only 25 percent of all CDOs a decade ago to about 80 percent of CDOs in 2018 (a 130 percent change). This also occurred in the midst of a shrinking CDO market, as shown in Exhibit 15 (Valladares 2018).

Exhibit 14

US CLO Issuance History

Exhibit14 - 2020-06-22A

Exhibit 15

US Outstanding Collateralized Debt Obligations

Exhibit15 - 2020-06-12A

CLOs seem to be a good option for institutional investors chasing plump yields. Two publicly traded, closed-end funds, Eagle Point Credit Company (ECC) and Oxford Lane Capital Corporation (OXLC) that focus on CLO equity (the riskiest tranches) could reach highly levered yields of up to 14 percent in 2019. More conservative funds investing in both debt and equity also generated yields of around 9 percent in 2019. Considering the impressive absolute performance, CLO default rates have been extremely low in recent years, even during the crisis. During 2006–2007, 96 percent of equity tranches paid off, and there were zero default cases from 1994 to 2013 in senior secured tranches. High yields and low default rates are what attract CLO investors.

Investors, however, should be cautious, given the hidden risks. Leveraged loans are provided to corporates with poor credit ratings. The market size of leveraged loans has doubled since 2008 to $1.3 trillion. It is equivalent in size to subprime mortgages immediately before the crisis. What CLOs do is to effectively turn these dubious debts into securities with high investment grade ratings, creating a false sense of safety for investors. Furthermore, as investor demand for securities increases, credit quality and underwriting standards for leveraged loans are deteriorating (while, as we have shown, ratings are inflating). CLO managers with little or no skin in the game are willing to accept higher debt multiples and weaker covenants.9 This same problem of lenders being incentivized to take outsized risks was a primary root cause of the 2008 financial crisis.


6 See corporate US trading volume from SIFMA,

7 The six firms include Apollo, CVC, Blackstone, Hellman & Friedman, Carlyle, and Warburg.

8 The CDO denomination here refers to structured finance CDOs, trusted preferred CDOs, collateralized bond obligations, collateralized loan obligations, and collateralized fund obligations. It does not include asset-backed securities.

9 The US Court of Appeals for the District of Columbia Circuit ruled in February 2018 that CLO funds will no longer have to comply with risk-retention rules, the “skin-in-the-game” rules designed to align interests between managers and their investors. United States Court of Appeals For The District of Columbia Circuit, The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System, October 10, 2017,$file/17-5004-1717230.pdf