Dwight Scott: The Case for Leveraged Loans
When markets experienced sharp declines early last year, they sent a powerful message about the expected impact of COVID-19 on the economy. In the loan market, the sell-off reflected not only that dire outlook, but also worries that the disruption could expose weakness in the structure of the loan and CLO markets and in the health of the underlying issuers. Some commentators even raised the possibility of broader economic effects.
Yet as 2020 came to a close, the loan market reflected a much more encouraging reality. In fact, leveraged loans exhibited exceptional resilience, with the US and European loan markets providing positive returns of roughly 2.5-3.0% for the year, fully retracing from the lows of March. This is not unusual, as leveraged loans globally have had positive returns in 17 of the last 20 years.
Collateralized Loan Obligations (CLOs)—which pool leveraged loans into a single investment vehicle—have been equally resilient. New issue AAA-rated CLO spreads in the US and Europe are nearly back to levels experienced prior to the downturn, and US CLO equity annual cash flow returns stand at 11.3% through December—their 10th consecutive year in the double digits. European CLO equity has likewise experienced the 10th straight year of double-digit cash flow returns, having posted a 13.2% return through December. Simply said, leveraged loans and CLOs successfully withstood 2020’s headwinds because they are well-structured securities that benefit from and support the strength of the underlying issuers as they participate in the nascent economic recovery.
Myth vs. Reality
Despite this evidence, some observers continue to raise fears about the leveraged loan market. Press articles have expressed concerns about loans as illiquid securities with minimal protections amid overheated market growth. These claims are detached from the reality of the market.
- Performance in 2020 showed that leveraged loans and CLOs remain resilient and stable. Access to liquidity remains strong for loan issuers, even during periods of economic stress. Indeed, recent support from the Federal Reserve, which was crucial early in the year for some markets, was not needed in leveraged loans.
- Contrary to forecasts in the heat of the crisis, loan default rates were manageable in 2020 and are currently declining. Loan principal loss rates also remain low despite a decrease in recovery rates.
- I believe leveraged loans are attractive because 1) they are often issued by companies backed by private equity sponsors, who may offer support in the event of financial difficulties; 2) they are typically senior secured and therefore first in line for payment in the event of default; 3) they can provide income even in today’s lower-rate environment; and 4) the fundamental and technical backdrop for loans should remain supportive.
- CLOs are equally attractive in my view because they typically 1) have resilient capital structures; 2) are actively managed; and 3) are highly diversified.
- In addition, a December 2020 study from the US Government Accountability Office concluded that leveraged lending is not a significant threat to financial stability.1
Missed Opportunity
Given the scarcity of yield in markets today, I believe there is opportunity in loans. Their secured nature is defensive, especially as the economic recovery remains in early stages. In my view, commentators have mischaracterized the risks in loans and CLOs. Not only have these assets proven their resilience—in today’s low-rate environment, they may provide an attractive solution for investors seeking income.
- U.S. Government Accountability Office, Agencies Have Not Found Leveraged Lending to Significantly Threaten Stability but Remain Cautious Amid Pandemic. Dec 2020.
The views expressed in this commentary are the personal views of Dwight Scott and do not necessarily reflect the views of The Blackstone Group Inc. (together with its affiliates, “Blackstone”). The views expressed reflect the current views of Dwight Scott as of the date hereof, and neither Dwight Scott nor Blackstone undertake any responsibility to advise you of any changes in the views expressed herein.
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