Monday, May 18, 2009

leveraged loan market - rough road ahead?

Let’s take a look at the US leveraged loan market. See the attached report from Markit. Looks like a 15%+ rally from the lows in mid Dec-05. Let’s see now:

  • 3.9% coupon (with LIBOR at ridiculously low levels and many loan facilities paying 1-month LIBOR instead of 3-months)

  • 4.4 years average life

  • $74 average price

That corresponds to a 5.2% yield assuming par recovery. Why would anybody buy this stuff – junk ratings, high default rates, poor recoveries, 5.2% yield? Again this means if no defaults occur, one would get a 5.2% IRR. In the past the argument was that this asset class presented a better risk adjusted return opportunity. Now we know the asset class can have equity-like volatility. The Sharpe ratio is under 0.5 (depending on future LIBOR assumptions and what one thinks about future volatility). The only way buying these loans makes sense is in leveraged non-mark-to-market vehicles (cash flow CLO’s) that don’t care too much about volatility.

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