Okay, now that you know what leveraged loans are and how big the market is, because you read my last article, you’re going to want to know the truth about how dangerous they are.
And, of course, you’re going to want to know how the pros are playing the market, and how you can make your own money when the next rumble turns into an earthquake.
The Problem with Leveraged Loans
Late last year, several big-name market mavens and big-time regulators began voicing concerns about inherent risks in the leveraged loan market.
From the regulatory side, concerns and comments came from the Federal Reserve, the International Monetary Fund (IMF), and the Bank for International Settlements (BIS), the so-called central bank for central banks.
Big bank leader JPMorgan chimed in, as did powerhouse global investment advisory and financial services giant, Guggenheim Partners.
Billionaire bond guru Jeff Gundlach of DoubleLine Capital LP and billionaire founder of Oaktree Capital, Howard Marks, sounded warnings about leverage in the leveraged loan market, as did countless others.
Janet Yellen, the former Chair of the Board of Governors of the Federal Reserve, reiterated warnings that declining underwriting standards for corporate loans could lead to more bankruptcies and prolong the next economic downturn.
With the size of the leveraged loan market well over a trillion dollars, making it larger than the junk bond market, they’re all right to be concerned.
What they’re worried about is “the prospect that an unwind could start tipping dominos on the way to creating a kind of self-fulfilling prophecy,” as one analyst put it.
Goldman Sachs, in a client note last year, warned, “Over-indebted corporations may be unable to repay their loans if interest rates rise meaningfully or earnings decline significantly [and] lenders may [then] cut back lending in response to a rise in defaults, which in turn would likely weigh on investment and activity.”
What got everyone so worried was what happened in the leveraged loan market when stocks started falling in October and continued falling through December.
Contagion Is What Happened
As stocks fell, other so-called “risk-on” investments enjoying a long bull run thanks to artificially low interest rates, exactly like leveraged loans, began to reverse course as interest rates ticked higher.
Not only did prices of leveraged loans in the secondary market start backing up, there was a freeze in new issuance of leveraged loans to already leveraged companies.
A striking example of the freeze in the loan market came when Bloomberg reported “that in a flashback to the events that culminated in the 2008 financial crisis, Wells Fargo and Barclays took the rare step of keeping a $415 million leveraged loan on their books after failing to sell it to investors.”
Wells Fargo & Co. (NYSE:WFC) wasn’t the only bank stuck in the freeze.
Several banks had to park hundreds of millions in unwanted paper on their balance sheets because they had agreed to finance loans, whether or not there was enough demand from investors.
With those loans on their books, banks risked the price of those loans falling further, as well as costs associated with holding loans.
Just as the leveraged loan market froze up outflows at mutual funds and ETFs loaded with leveraged loans accelerated to record levels.
All that was frighteningly reminiscent of what happened in late 2007 and early 2008, when massive flows of debt deals suddenly had no takers and had to be warehoused with issuers, and they ended up taking massive haircuts on the bonds they couldn’t sell.
It’s not just the surface that’s rippling.
Under the leveraged loan surface lie more insidious products, where more games are being played.
One risk play used by hedge funds and others is to buy small amounts of leveraged debt of risky companies at a discount, and then buy a much larger amount of insurance on that debt – so-called “credit default swaps” – to theoretically hedge their risk.
These players then do what they can to force the company into a bankruptcy filing, which contractually triggers the insurance payoff on the debt.
Since the insurance payout grossly exceeds the cost of the discounted debt, the funds profits handsomely.
Then bankruptcy filings send the company and its creditors, including investors in C.L.O.s, chock full of defaulting companies’ loans, into a downward spiral, hurting everyone but the players and their cohorts orchestrating the dance.
And that’s just one game being played.
Another is the orphaned CDS game. But, that’s another story for another time.
We saw the quick selloff in the leveraged loan market from October 2018 accelerating into December, that was everyone’s early warning.
Then the Fed stepped in and saved the day for leveraged loans and equities, by backing off its announced rate hikes.
Next time the Fed raises, and they will eventually raise, the markets may not be so lucky and get thrown a lifeline.
Or worse, if the economy falters and leveraged companies can’t meet debt service obligations, they may fall like dominos.
Stick with me and I’ll tell you exactly how we’re going to ring the register many times over with simple strategies to rake in gains when the leveraged loan market gets raked over.
And it’s why all of my subscribers to Money Zone had the opportunity in the first week of November to secure 5 double-digit returns and 2 triple-digit profits in just one week! See here how you could’ve done it too.