Covenant Weekly Market Synopsis for August 10, 2018

August 13, 2018

Last Week Today:  Tesla’s CEO and major shareholder Elon Musk Tweeted the possibility of taking Tesla private at $420 per share – TSLA’s price jumped 11%; the SEC is investigating Musk’s claims that financing for the privatization was “secured” and several shareholder lawsuits have been filed relating to the veracity of the tweet. | China announced 25% tariffs on $16 billion of U.S. imports. | U.S. introduced new sanctions on Russia for poisoning a former Russian spy in Britain – Russian Ruble declined to its lowest level in nearly two years. | Turkey’s currency (the Lira) fell 15% on Friday, and 23% for the week, following President Trump’s announcement of sanctions and increased tariffs to pressure the country to release an American pastor arrested two years ago by Turkish authorities. In addition to the Lira taking a beating, Emerging Market (-2.1%) and EAFE (-2.0%) stock indexes suffered on Friday.

What looked to be a promising week for risk assets fell apart on Friday as the situation in Turkey came to the fore and fears of financial market contagion sucked the wind out of generally positive investor sentiment. Domestic equity markets were pressured, but not nearly to the extent of international equity markets. Conversely, safe haven US Treasury bonds were bid, and the yield on the benchmark 10-year UST once again retreated from the 3% threshold, a level it is not reliably held since before 2011. Commodities, were caught in Turkish whirlwind on Friday as well, though the desynchronization of global growth has been a headwind since May. The US Dollar Index rose 1.2% (another safe haven trade) and the VIX Index jumped 13.1% for the week (though at a level of 13.2, it is hardly indicating market panic).

For detail on weekly, month-to-date and year-to-date asset class performance, please click here.

Peak Growth?  Second quarter growth in the U.S. economy was impressive as anticipated. The Bureau of Economic Analysis’s (BEA) first estimate of real, annualized growth for Q2 is 4.1%, representing the fastest quarterly rate of expansion since Q2 2014’s 5.1% annualized growth.

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As impressive as the Q2 acceleration is, we believe extrapolating this growth into the future is a mistake. Sure, the economy can continue to expand at an above-trend rate for a few quarters, and while Q2 may not mark peak growth, we don’t believe this is the beginning of a new cycle of 4%+ growth. Indeed, 3%+ may be a challenge beginning in 2019 as fiscal stimulus wanes and the Fed continues to tighten its monetary policy screws. We cover these topics in more detail in our “Mid-Year Economic Review and Outlook,” which is scheduled for release late this week.

Leveraged Loans Ain’t What They Used To Be.  Since the globally coordinated effort by central banks to reduce interest rates following the Great Financial Crisis, investors have been starved for yield. Low coupon payments from traditional fixed-income investments pushed institutional and retail investors alike to explore other sources of yield investments, including high yield bonds, preferred equity, and, increasingly, leveraged loans.  Although leveraged loans are issued by non-investment grade companies, they have been a favored destination because of the perceived safety of the investments: the loans are typically senior in the capital structure of the borrower, and the interest rates on the loans are floating (meaning the rates move higher or lower with market rates, therein providing protection from rising interest rates).  In a “virtuous” circle, high demand for these types of loans has also made them a favorite kind of debt for issuing companies. While the high yield bond market remains larger in overall size, leveraged loan issuance is on pace to reach $1.5 trillion in 2018, a more than 50% increase since 2016 (Source: Bloomberg).

The adjective “virtuous” is in quotations because high demand for leveraged loans has contributed to the negotiating power of corporate issuers and investors have acquiesced, accelerating growth in issuance of covenant-lite loans. In fact, covenant-lite loans have increased from 5% of the leveraged loan market before 2007, to nearly 80% of the leveraged loan market today.

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Loan covenants stipulate what provisions a borrower must follow to preserve the interests of the lenders (i.e., whoever purchases the loans). Typical covenants include financial maintenance restrictions (e.g., minimum interest coverage and maximum leverage ratios) and ensuring the position of the lenders remain senior in the capital structure. However, torrid demand has spurred the growth of covenant-lite loans which have no financial maintenance restrictions. Incredibly, many of these covenant-lite loans give borrowers the flexibility to issue more debt, pay out dividends, and even remove collateral that was supporting the original loan issuance. According to Moody’s Investor Services, “We have never seen weaker loan covenants. That includes prior to the financial crisis”.

The message here, as usual, is caveat emptor. To earn a return on an investment, you must bear some type of risk. The question investors in leveraged loans must ask themselves is whether the risk of diminished controls on borrowers is worth the additional yield available over traditional fixed-income investments. While the data on default recoveries for recently issued covenant-lite loans is limited by the small number of defaults since 2010, early results are discouraging. Nevertheless, the low recovery rate thus far serves as a powerful reminder that return of capital is more important than return on capital.

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Be well,

Jp.