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Increasing Risk in Leveraged Loan Market is Worrisome for Economy: Remember 2007

Increasing Risk in Leveraged Loan Market is Worrisome for Economy: Remember 2007.  Jon Harris of Alternative Investment Management, LLC has done a great job explaining the increasing danger in the leveraged loan market. This is evident as once again the bond rating agencies, despite the economic havoc they caused in 2007, are playing loosey goosey by increasingly assigning BBB ratings to many offerings that would have been assigned junk ratings in the past. (See chart below on loan ratings). Harris notes that while most fund managers consider a trade war with China the biggest risk to the economy,  they should be paying more attention to the potential economic havoc from a bond market bubble like the one that occurred in 2007.

He points out that Zero Hedge reported in October that the average leverage for BBB-rated companies has increased from 2.0x to 3.2x in the past eight years. Meanwhile, Morgan Stanley notes that more than half the BBB debt in the past would have had a junk rating based on debt alone. Moreover, the Wall Street Journal reports about 57% of companies purchased in leveraged buyouts now carry debt loads more than six times their EBITDA. That exceeds the 51% ratio in 2007 on the eve of the financial crisis, according to Morgan Stanley data.”

We should add that there’s a simple reason the ratings agencies are willing to give BBB ratings to what really are junk bonds. The answer is greed. They are paid by the principals involved in a bond offerings who can always go to a competitor if they are not happy. Meanwhile, unfortunately investment professionals often foolishly take oversized risks to maximize returns.

“Those who cannot learn from history are doomed to repeat it.” George Santayana

Increasing Risk in Leveraged Loan Market is Worrisome for Economy: Remember 2007
Increasing Risk in Leveraged Loan Market is Worrisome for Economy: Remember 2007

We view this trend as more evidence of investors searching for yield in a low interest rate environment. Reinforcing this point, ZeroHedge reported in October that the average leverage for BBB-rated companies has increased from 2.0x to 3.2x in the past eight years. According to research from Morgan Stanley, more than half of all BBB debt would have a junk rating based on leverage alone. (We ask ourselves, what are the rating agencies thinking?) We are particularly concerned about the lending practices of companies owned by private equity funds. According to a report in the Wall Street Journal, about 57% of companies purchased in leveraged buyouts now carry debt loads more than six times their EBITDA. That exceeds the 51% ratio in 2007 on the eve of the financial crisis, according to Morgan Stanley data.

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Brad Lamensdorf

Brad Lamensdorf, the founder and portfolio manager of Active Alts, is a principal and co-manager of the AdvisorShares Ranger Equity Bear ETF. He previously managed a long-short investment partnership from 1998-2005 under the name Tarpon Capital Management. Earlier in his career Mr. Lamensdorf was an equity trader/market strategist for the Bass Brothers’ trading arm. He managed a short only portfolio in addition to co-managing a $1bil hedging program. He also served as in-house market strategist for the entire internal and external network of Bass Brothers money managers.

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