Jack Yang, a managing partner at Highland Capital Management, which manages $30 billion in debt investments, offers his views on the current state of the bank loan market.
The global financial crisis has generated unprecedented volatility in the loan market, with credit spreads near their highest levels in history. The collapse of the subprime mortgage market had a contagion effect on all structured products including collateralized loan obligations, or CLOs, which are backed by bank loans.
This has resulted in one of the most rapid and severe periods of asset deleveraging in history.
Technical factors, such as the suspension of the CLO market, historically one of the largest buyers of loans, and forced selling by hedge funds and banks have driven prices down to levels never seen before.
The fall in the loan market has far outpaced the deterioration in fundamentals, even assuming that global economic fundamentals continue to worsen.
In October 2008, more than $3 billion in loans were auctioned off as CLOs and other financing programs unwound. Massive deleveraging in the market drove the S&P/LSTA Leverage Loan Index down a previously unthinkable 29.1 percent at the year’s end, before seeing positive momentum with returns of 9.8 percent through the first quarter of 2009.
Measured by implied default rates, loan valuations are cheap.
With the average price of loans around 65 at the end of March, the implied default rate, according to S&P Leveraged Commentary & Data, is roughly 45 percent, far exceeding the previous actual default peak of 8.2 percent in 2000 and the current 4.8 percent default rate, as measured by the number of issuers.
While it is anticipated that defaults will rise above previous peaks, we believe it is highly unlikely they will come close to the level implied by current prices and spreads.
This record disparity between actual and implied defaults means loans’ current risk premium should offer a sizable cushion against rising defaults. Loan prices are now trading about five points below their historical recovery rates of 70 percent (1990‐2008) 30 days after default, and well below their 80 percent historical recovery rate after a workout.
By both measures, today’s levels are difficult to justify based on fundamentals.
The extreme market stress has obscured the market’s fundamentals. Over the past 10 years, loans trading above a price of 90 have comprised the lion’s share of the market. At the end of first quarter 2009, 53 percent of loans are priced below 70, unlike the previous correction in October 2002, when only 15 percent of the market traded below 70.
We believe this disparity is attributable to the more technical and illiquid nature of today’s market rout as a result of indiscriminate, motivated selling, as opposed to the fundamental nature of the prior recession. In the absence of well‐reasoned credit analysis, good and bad credits are being grouped together.
Investors with strong credit research capabilities and experience in evaluating recovery values can potentially purchase high-quality assets at what may prove to be fire-sale prices resulting in significant absolute and relative performance.
The extreme turmoil in the credit markets has caused the price levels of higher‐rated assets to converge with those of riskier assets. We believe it is very difficult to justify today’s current valuations in loans, even if it is assumed that global economic fundamentals will continue to worsen. While a direct path to recovery is unlikely, we see no reason to overlook the current potential risk‐return profile of bank loans.
As in previous cycles, we anticipate the market’s healing will begin with the highest‐rated asset classes, and then move down the capital structure with increasing signs of economic stability, market improvement, and ultimately, liquidity.
Jack Yang is a managing partner at Highland Capital Management. He is based in New York.