The Lowdown on Leveraged Loans

Aggressive investors may find funds that offer an intriguing way to play a coming wave of corporate defaults—but the risks are considerable

By David Bogoslaw

With credit woes cutting a broad swath through the stock and bond markets—and given the scrutiny that's been paid to the role leverage played in the financial crisis—it's understandable that investors should be shunning any asset class carrying even a scrap of risk. When it comes to leveraged loans, the secured bank debt that private equity heaped on companies in order to acquire them through leveraged buyouts, the deep aversion makes even more sense. The reason? Experts believe many of these companies will default on their debt as a result of the recession.

But risk is a two-sided coin in finance. Fund managers who invest in leveraged loans say the current distressed market prices offer a once-in-a-lifetime opportunity to own assets that will deliver huge returns over the long run. A word of caution, though: The mutual funds making these bets are more suitable for people with a long-term time horizon for their portfolio, not those looking for some quick asset allocation fix, says Bill Larkin, portfolio manager for fixed income at Cabot Money Management in Salem, Mass.

The primary draw of leveraged loans for the pros: When a company defaults on its debt, holders of bank loans, which have certain of the borrowers' assets and/or stock pledged as collateral, are higher up in the capital structure and generally get paid before holders of unsecured debt and equity holders. And these loans can be bought at sharply discounted prices, around 65 cents on the dollar on average, say fund managers.

The discounts have little to do with questions of fundamental value and more to do with the sheer volume of selling by hedge funds and other owners who need to raise cash quickly to meet margin calls and a heavy volume of redemption requests by holders of their funds. With funds looking to dump the loans en masse, most leveraged-loan investors are laying back, wary of being burned if the market still has a way to go before reaching bottom.

Unprecedented

This is the first time in the history of the asset class that leveraged loans offer potential for equity–like returns, said Tom Ewald, chief investment officer for bank loans at Invesco AIM Worldwide Fixed Income, on Invesco AIM's Web site.

Still, the credit freeze and mounting worries about corporate debt defaults likely to result from what's projected to be the worst recession in 26 years have dealt a body blow to the performance of mutual funds that specialize in bank loans. Mutual funds—and closed-end funds, which trade like equities—are the most logical way for retail investors to participate in leveraged loans.

These funds' returns are down 18% to 32.3% year-to-date as of Dec. 10. The losses at closed-end funds are much higher, around 50% year-to-date, due more to worries about the 25% leverage positions those funds hold and their ability to maintain high monthly dividend payments than concerns about the actual asset class.

The credit quality of the loans in the Eaton Vance Floating-Rate Fund-Advisors Shares (EABLX) "has ebbed and flowed within a narrow margin pretty much forever," says Scott Page, co-manager of the $2.51 billion portfolio. "One thing that's different this time is the companies are larger because private equity firms were buying larger companies" and getting larger loans to finance them during the recent leveraged buyout boom.

"Not Reality-Based"

That's the main reason for the dramatic drop in prices for bank loans, which are down 20% to 25% in the last 120 days, loss rates not seen in 25 years, he says. "It is not reality-based in terms of what I focus on," which is mostly companies' ability to repay their debt and, if they can't, what the reasonable chances are of the fund recouping most of its investment.