The Biggest Reset Looms for Corporate Credit Market

[tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience.” line_height=”1.4″][tm_spacer size=”lg:25″][tm_heading tag=”div” custom_google_font=”” text=”Leveraged loans,” extended to junk-rated and highly leveraged companies, are too risky for banks to keep on their books. Banks sell them to loan mutual funds, or they slice-and-dice them into structured Collateralized Loan Obligations (CLOs) and sell them to institutional investors. This way, the banks get the rich fees but slough off the risk to investors, such as asset managers and pension funds.”][tm_spacer size=”lg:63″]
[tm_image image=”875″][tm_spacer size=”sm:30″]
[tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Use psychological pricing methods.” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”This has turned into a booming market. Issuance has soared. And given the pandemic chase for yield, the risk premium that investors are demanding to buy the highest rated “tranches” of these CLOs has dropped to the lowest since the Financial Crisis.”][tm_spacer size=”xs:30;lg:35″][tm_heading tag=”div” custom_google_font=”” text=”Mass Mutual’s investment subsidiary, Barings, has packaged leveraged loans into a $517-million CLO that is sold in “tranches” of different risk levels. The least risky tranche is rated AAA. Barings is now selling the AAA-rated tranche to investors priced at a premium of just 99 basis points (0.99 percentage points) over Libor, according to S&P Capital, cited by the Financial Times.”]
[tm_spacer size=”xs:30;lg:52″][tm_heading tag=”div” custom_google_font=”” text=”Also this week, New York Life is selling the top-rated tranche of a CLO at a spread of less than 100 bases over Libor. And Palmer Square Asset Management sold a $510-million CLO at a similar premium over Libor. In the secondary markets, where the CLOs are trading, red-hot demand has already pushed spreads below 100 basis points. These are the lowest risk premiums over Libor since the Financial Crisis.”][tm_spacer size=”xs:30;lg:68″]
[tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Demonstrate the differences” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”These floating-rate CLOs are attractive to asset managers in an environment of rising interest rates. If rates rise further, Libor rises in tandem, and investors would be protected against rising rates by the Libor-plus feature of the yields.”][tm_spacer size=”sm:30;lg:68″][tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Offer a money-back guarantee” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”Libor has surged in near-parallel with the US three-month Treasury yield and on Monday reached 1.83%. So the yield of Barings CLO was 2.82%. While the Libor-plus structure compensates investors for the risk of rising yields and inflation, it does not compensate investors for credit risk!”][tm_spacer size=”sm:30;lg:68″][tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Test your offer and price, and be creative.” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”These low risk premiums over Libor are part of what constitutes the “financial conditions” that the Fed has been trying to tighten by raising its target range for the federal funds rate and by unwinding QE. It’s supposed to make borrowing a little harder and a little more costly in order to cool off the credit party.”]
[tm_spacer size=”sm:40″][tm_image full_wide=”1″ image=”876″]

More Signs of Private Equity Market Frenzy: Firms Selling Stakes

[tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”As an insider once told me, the most important skill that private equity firms possess, aside from their ability to hide their sociopathic tendencies, is their finely-honed sense of when to sell.” line_height=”1.4″][tm_spacer size=”lg:25″][tm_heading tag=”div” custom_google_font=”” text=”A Wall Street Journal report today is therefore a strong indicator that the private equity is at or near a market peak. In Private Equity Bubble? What Private Equity Bubble? the Journal describes how firms are selling ownership stakes. Recall that the last time that happened was in 2007. Blackstone launched its IPO just before the crisis. KKR filed for an offering in 2007 but missed the window.”][tm_spacer size=”lg:63″]
[tm_image image=”875″][tm_spacer size=”sm:30″]
[tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Use psychological pricing methods.” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”The amusing part of the story is the effort of the parties who have acquired interests in private equity firms recently, are keen to do so, or are otherwise allies of general partners to depict these firms as great buys. These purchases are taking place when the private equity industry has been paying nosebleed prices for deals for two years and central banks are looking to end their massive monetary stimulus. “][tm_spacer size=”xs:30;lg:35″][tm_heading tag=”div” custom_google_font=”” text=”Even the ECB, which was a believer in super low and negative interest rates after the Fed recognized that its QE experiment hadn’t worked out as it had expected, is now looking to unwind QE, then raise rates.”]
[tm_spacer size=”xs:30;lg:52″][tm_heading tag=”div” custom_google_font=”” text=”Thus the tremendous central bank tailwind to asset prices is not only stopping but is going to start turning in the opposite direction. Even though any tightening is sure to be administered slowly and with great caution, a central bank regime change is unfriendly to risky investments like private equity.”][tm_spacer size=”xs:30;lg:68″]
[tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Demonstrate the differences” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”The boosters also tout private equity’s supposedly illustrious returns, which as we’ve written repeatedly, are in fact exaggerated. Private equity firms use IRR, which is a misleading metric. For the last decade, private equity has regularly underperformed public equities on a risk-adjusted basis.”][tm_spacer size=”sm:30;lg:68″][tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Offer a money-back guarantee” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”Moreover, the story depicts the entry of sovereign wealth funds and family offices as direct private equity investors as a plus for private equity, when that is a negative.”][tm_spacer size=”sm:30;lg:68″][tm_heading tag=”h5″ custom_google_font=”” font_weight=”600″ text=”Test your offer and price, and be creative.” line_height=”1.4″][tm_spacer size=”lg:23″][tm_heading tag=”div” custom_google_font=”” text=”First, more parties bidding up deals means even more likelihood of overpayment and disappointing returns. Second, these very same sovereign wealth funds and family offices have been significant private equity fund investors.”]
[tm_spacer size=”sm:40″][tm_image full_wide=”1″ image=”876″]