The worst is yet to come for the $1.2 trillion market for junk-rated leveraged loans (compared to the roughly $9 trillion mortgage-backed security market that went bust during the 2008 financial crisis).
We first warned of severe stress in the riskiest segment of the credit market back in November 2019. Since then, an extreme sell-off began across risk-assets, precipitated by the global pandemic.
Despite some relief in the corporate credit market over the past week, our research finds that underlying stress remains. Therefore, a temporary risk-rally could present opportunities to dampen portfolio volatility with defensive positioning for the time being. In doing so, Treasury inflation-protection securities (TIPS) could help to protect the value of the fixed income allocation.
Credit crunch is out of regulatory control
Regulators are also concerned about investors chasing yield in high-risk companies. In December, the Financial Stability Board (FSB) admitted that little is known about the exposure of certain nonbank investors to these leverage loan markets.
“As a former banker, I think leveraged loans are an area where investors’ liquidity expectations might not match up with reality, and the SEC should do all we can to help investors understand that,” says former SEC Commissioner Robert Jackson Jr in April 2019.
“The question is, is it time to go to Congress to get a new law to make sure the SEC can do that work?”
Clearly, the Commissioner’s concerns fell on deaf ears.
We expect further selling of risky debt
Risk exposure is growing, and there’s only so much of the bad stuff that funds can hold before they begin selling en masse in order to meet the cash needs of their clients.
Here’s how the risk is distributed.
And there's less protection against adverse scenarios. First-lien covenant-lite loan debt cushions fell dramatically over the last nine years to just under 18% in 2019, from an average of 33% pre-crisis, according to Moody’s. These debt cushions remain the primary factor in determining investors’ recoveries on defaulted debt.
Further, more downgrades could impact CLOs currently holding single-B debt. According to S&P, these CLOs have 7.5% of CCC-rated bucket limits, which means they will have to sell weak loans and experience realized losses on their books.
What does this mean for asset allocation?
For now, avoid taking on more credit risk despite tactical relief
We see limited upside ahead for US corporate high-yield versus investment-grade
Instead of immediately dialing up portfolio risk, we view opportunities in short-term inflation protection as a hedge against long-duration Treasuries