Not everything in fixed income securities is as nailed down as the name. Leveraged corporate loans with floating rates have been among the hottest debt products marketed on Wall Street in recent years.
Financial engineers rigged up so-called “collateralised loan obligations” bundling pools of corporate loans into slices of varying risk. Many of these loans were priced at a spread floating above a benchmark rate. They were intended to serve as a hedge when interest rates finally drifted upwards from zero.
Trillions of dollars of these loans were issued, well ahead of the junk bond market. Insurers eagerly swallowed the senior-ranked paper.
The days of higher interest rates have now arrived. Loan holders are enjoying higher interest payments for now. But no one wants to see a soft economic landing more than them. Those increased cash flows are of little use if issuers default
These worries crystallised last week when the Fed raised its target rate by 75 basis points amid galloping inflation. The S&P LSTA loan index fell by 1.11 per cent reducing returns for the year to 2.79 per cent.
New deals are scarce, given the reset cost of capital. The financing for a high profile LBO of Intertape Polymer Group by Clearlake Capital is illustrative.
Intertape recently sold junk bonds eventually priced at a hefty effective yield of 14 per cent. The senior loan component — $1.5bn — had to offer an initial yield of 8 per cent, including an initial discount price of 92 cents on the dollar. In deals like these, Wall Street banks committed to pricing months ago when conditions were more benign. Losses could be meaningful unless markets rebound.
The loan default rate, according to S&P data, hit an all-time low in April, at just 0.26 per cent. The economy and consumer spending have remained resilient for now. But the Fed seems intent on crushing inflation by any means necessary.
The question investors need to ask themselves is this. How valuable is inflation protection likely to be, once they have written off the cost of paper that becomes worthless?
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