High-Yield Debt, Ease of Underwriting Standards, and Rise in Interest Rates: The Trifecta for a Crisis
September 28, 2015
High-yield debt issuances have increased rapidly the past few years; loan structures continue to weaken with "covenant-lite" transactions dominating issuances; and interest rates are set to rise, triggering increases in variable interest rates on this high-yield debt. This trifecta of events is creating the groundwork for the next credit bubble. When the bubble bursts, investor losses, governmental investigations, and litigation are the likely consequences.
The volume of high-yield debt issued in the market reached a low ebb in 2008, but started to accelerate from that low point to a record level of high-yield debt issuances in 2014. Furthermore, hundreds of billions of dollars of this new debt is scheduled to start coming due in 2016, and will continue to increase in direct correlation with the increased debt issuances. The inability of weaker issuers to refinance this maturing debt may add further complexity and uncertainty to the high-yield market.
High-yield debt issuances, commonly referred to as "junk bonds", are considered loans, and the SEC does not regulate them. In fact, borrowers and underwriters can even limit who can access their financials, control the type of data they get, and even blacklist certain investors from ever buying the loan. Case and point- Millennium Health. According to people with knowledge of the matter, the company compiled a blacklist that prohibited dozens of big-name funds from buying the loan through its maturity. Millennium's blacklist primarily included distressed-debt buyers, because it did not want these buyers advocating for increased creditor rights.
The problem lies here: these "leveraged loans" issued by junk-rated, over-leveraged companies, are too risky for banks to keep on their books, so they sell them directly or as collateralized loan obligations (CLOs) to institutional investors. Since CLOs did not implode as did its collateralized debt obligation (CDO) counterparts in the recent recession, investors have gravitated to CLOs as a way to achieve outsize returns above other fixed income products. Investors say they are drawn to CLOs because they are marketed as having high returns at a similar perceived risk level as U.S. Treasury bonds.
However, CLOs are offered in an illiquid market. If the underlying high-yield debt falters, there is no easy way for investors to unload them without a significant loss. Such illiquid investments could spell disaster for investors, such as funds required to dispose of losing investments or a regional bank in need of cash.
Over the past few years, loan structures have continued to weaken with "covenant-lite" transactions dominating institutional issuance at 74 percent due to an easing of underwriting practices. Similarly, there have been higher levels of leverage creeping into the high-yield market with riskier borrower profiles. This combination of higher initial leverage, weaker loan structures, and riskier borrower profiles indicates increasing credit risk.
The Office of the Comptroller of the Currency's 20th Annual Survey of Credit Underwriting showed banks have eased underwriting standards, and increased levels of credit risk, in response to competitive pressures, abundant liquidity, and desire for yield in the low interest-rate environment. Leveraged loans, large corporate loans, and international loans experienced the most easing in standards continuing the trend from the previous year. Not surprisingly, large banks, and especially large banks with investment banking operations, eased their standards more than midsize and community banks.
As if all of this was not enough to keep investors up at night, the prolonged low interest rate environment continues to lay the foundation for future vulnerability. Some investors have "reached for yield" or extended maturities to boost interest income with decreasing regard for interest rate or credit risk. Even large asset managers are encouraged to reach for yield on behalf of their clients in the current low interest rate environment.
However, the impending uptick in interest rates will further deteriorate these high-yield debt products, both whole loans and CLOs, as repayment obligations will increase on already tenuous debt offerings.
The Result of the Trifecta
Ultimately, the consequences of the trifecta will affect players from all different areas of the financial realm. Investors are going to lose, both through investment in whole loan portfolios and CLOs; CLO managers are going to be forced to choose between the issuers/underwriters who provide them with their loans and the investors who demand recovery for their damages; and, the underwriters are going to have to figure out how to extricate themselves from this mess without insurmountable legal costs.
As a result, financial institutions and issuers active in the high-yield market may face a new wave of claims similar to those brought by investors who lost money following the burst of the subprime mortgage bubble six years ago. As illustrated by the litigation arising from losses sustained during the subprime crisis, even sophisticated investors may have claims against issuers and underwriters of high-yield debt structured finance products.
Whatever the particular nature of the structured product investment vehicle, it is all but certain that the next wave of claims could include allegations that the issuers and underwriters of high-yield debt products had superior knowledge regarding the risks associated with the products and failed to share such knowledge with investors; or that these sell-side parties breached duties and obligations set forth in the transaction's governing documents. The primary claims would be that the underwriters of the CLOs, synthetic CLOs or other hybrid type products, did not disclose the true nature of the deteriorating underwriting standards of the high-yield debt or the risks inherent in such structures. There may also be specific claims tied to the transaction's governing documents, similar to those relating to an asset-backed securitization.
Furthermore, CLO Managers are subject to risk retention requirements, and have a responsibility to inform their clients about the declining value of assets in the CLO funds. These Managers owe a fiduciary duty to their clients, and must provide objective discretion over valuation levels. The lack of regulation and oversight in the high-yield debt market will act as catalysts to unveil the deficiencies in this model.
Nonetheless, not every CLO or high-yield debt investment that loses money will be litigation worthy. The key will be to identify the structured finance products whose losses, or portion of losses, were due to improper disclosures, poor due diligence and poor structuring of the offering. These are the types of claims that would allow the investors to seek recovery of their losses or, alternatively, may be an investment tool for distressed debt investors.
The ultimate question becomes not if, but when, will the trifecta eventually come to a head and create the cataclysmic financial crisis that lies ahead? Most investors are aware that high-yield debt and its securitized products will be negatively affected by the impending rise of interest rates. However, many investors fail to recognize how other attributes of their high-yield debt products - particularly weak loan and securitization structures and weak underwriting - will serve to accentuate these negative interest rate effects. Do you understand the structure and know the underwriting standards of your high-yield debt and related securitized products?
Reprinted with permission of Seeking Alpha © 2015
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