Vulture investors in fixed income securities are mainly hedge funds and other institutional investors, but there will soon be some good opportunities for retail investors in leverage loan closed end funds.
Leveraged loans are unregistered loans made by banks to lower rated non-investment grade corporate borrowers. These are typically longer term loans with floating rates spread above LIBOR. In some ways, they are similar to high yield bonds, and some non-investment grade corporate borrowers use both leveraged loans and high yield bonds. But there are some important differences:
- Leveraged loans are more senior in the capital structure and are secured. They are structured to include a lien against assets which can be sold off or operated for cash. High yield bonds are senior unsecured and are behind loans in the pecking order when there is a default.
- Leveraged loans are floating rate, high yield bonds are fixed rate.
- Effective duration of leveraged loans is shorter. Much less interest rate risk.
- Leveraged loans have strong covenants which are minimal for high yield bonds.
- Default recovery rates for leveraged loans are about 80% versus 30-40% for high yield bonds.
In spite of many advantages, leveraged loans have recently dropped significantly in price because of the credit liquidity crunch- not because of any problems with the underlying securities. Open end mutual funds that invest in leveraged loans have experienced 18 straight weeks of fund redemptions which means forced selling.
To make things worse, several hedge funds have recently been forced to unwind
total return swaps (TRS) financing programs. TRS lines are used by hedge funds and market value
CLO obligations to borrow from banks to buy debt instruments such as leveraged loans in the open market. Market value CLO’s (unlike cash flow CLO’s) must mark to market their underlying loan assets at the end of each day. As the price of leveraged loans has fallen, investors using TRS financing face repayment similar to a margin call. Some irresponsible hedge funds and CLO’s have used leverage of 400% up to as high as 1000%.
Once the market stabilizes, a good way for retail investors to buy leveraged loans is to use closed end funds selling at a discount to NAV. That way you get a discount on assets that are already heavily discounted by forced selling. A few closed end funds in this space to look at are:
PHD,
JFR,
EFR,
EFT,
JRO
Full Disclosure: I do not currently own any of the above funds, but have placed them on a watch list for potential future purchases.
