(Bloomberg Opinion) -- Everyone seems to have a fear they just can’t shake. Maybe someone was stung by bees as a child and is frightened by them as an adult. Perhaps flying in an airplane is terrifying, even though statistics show it’s safer than getting in a car.
For fixed-income traders, that fear is illiquidity. The idea of being stuck in an investment with no way out other than to sell at a fire-sale price and take a steep loss is undoubtedly painful to contemplate.
That sort of distressing situation, of course, has made for splashy headlines lately. H2O Asset Management came under scrutiny last month for owning what amounted to loans repackaged into private placements. Morningstar Inc. published a report questioning the “liquidity and appropriateness” of some holdings, which sparked huge withdrawal requests, which naturally raised questions about whether it would have to take drastic actions like other pressured fund companies such as Woodford Investment Management and GAM Holding AG. Just last week, Bank of England Governor Mark Carney put yet another spotlight on illiquidity, saying that Neil Woodford freezing his flagship fund demonstrated the risks associated with money managers amassing hard-to-sell assets.
Now, with all that as a backdrop, imagine a $693 million leveraged loan that was trading at 97 cents on the dollar losing about a third of its value in one day. At first glance, it would seem the illiquidity boogeyman has made it to the other side of the Atlantic.
This is effectively the recent saga of Clover Technologies:
Clover’s loan isn’t especially large by Wall Street standards, yet its stark and swift decline set off fresh alarm bells — bells that regulators have been sounding for months. It immediately became a real life example of the perils of investing these days in the $1.3 trillion market for leveraged loans, where a global chase for yield has allowed an explosion in borrowing and lax underwriting. In a market where trading can be thin — and at a time when illiquidity is suddenly becoming a prominent concern in credit circles — the episode shows how loans to highly leveraged companies can quickly implode when fortunes change.
When buyers “head for the exits at the same time, prices can drop fast and furiously” given the lack of liquidity, said Soren Reynertson of investment bank GLC Advisers & Co., which specializes in debt restructuring.
The key phrase, to me, is “when fortunes change.”
Make no mistake, this loan checks just about every box for a risky investment. Clover was acquired by private equity firm Golden Gate Capital, which ramped up leverage to extract dividends for itself. The loans were light on investor protections, or covenants, giving buyers less insight into how the company was performing. Both of these elements are pervasive throughout the $1.3 trillion leveraged-loan market.
But they’re not really the reason Clover’s loan plunged. Instead, it was a significant credit event on July 9:
Clover disclosed that day it had lost two key customers and hired advisers to study its options. The price of its loan quickly plummeted from 97 cents to around 65 cents, which put it in the distressed category.
Two days later, Moody’s downgraded the company a notch to Caa3. It cited its “aggressive financial policies, evidenced by its private equity ownership and history of shareholder distributions and large debt-funded acquisitions.’’
Moody’s now predicts a higher likelihood Clover will default on its debt obligations. The ratings agency cites concerns over long-term viability of the business and “unexpected” operational developments. Its debt is just over 6 times its earnings, a level that typically raises lender concerns about the company’s ability to meet its financial obligations.
Look, I’m sure it was not fun to be managing of one of those mutual funds or collateralized loan obligations holding Clover’s loan when it made that disclosure, particularly because the downgrade probably forced them to sell. But this doesn’t rise to the level of a liquidity scare in my book. Rather, it’s a reminder that companies can struggle, or even fail, which admittedly is a novelty during an era in which central-bank stimulus and ultra-low interest rates are allowing zombie firms to muddle along indefinitely. When something of this magnitude happens, market prices will tumble, no matter if it’s a publicly traded stock, a speculative-grade bond or a loan.
What should be concerning to leveraged-loan investors is the rise of so-called enhanced CLOs, which are effectively a wager that more companies will go the way of Clover and get downgraded to the triple-C tier. These new funds are allowed to have up to half their portfolios in triple-C debt, while traditional CLOs are only permitted a fraction of that exposure. As my Bloomberg Opinion colleague Matt Levine quipped, “In finance, the way to enhance something is to make it worse.”
“Investors say there is ample evidence that the limited ability of CLOs to hold triple-C loans creates unusual price moves” in leveraged loans, the Wall Street Journal reported. Since November, three different managers have issued $1.6 billion of these enhanced CLOs in a bet that they can pick out which loans have fallen too far from which are legitimately veering toward default.
Something tells me that’s easier said than done. Catching a bunch of falling knives will at best come with a few deep cuts, and at worst take off your entire hand. It’s asking for trouble, though they’ll likely be doing the broader market a service by making price swings around downgrades a bit less volatile. Who knows — maybe they were the ones who stepped in to buy Clover’s loan.
In the meantime, it’s worth taking a step back and remembering what the leveraged-loan market is at its core. It has seen explosive growth and as a result is filled to the brim with credit risks and liquidity risks. One-offs like Clover are usually the former. But it’s the latter that will continue to keep investors up at night.
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Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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