Leveraged Loans Break 6 Week Winning Streak

Posted by Ray on August 21, 2009 under Main | Be the First to Comment

The area of leveraged loans, high yield or junk bond, index has been on a tear for the past six weeks with over a 6% gain the leveraged-loan index is up 41% YTD. Much of the optimism for higher yielding securities is the stimulus package and, what some believe, the easing of the recession, the stimulus package and the Fed’s intervention to encourage this type of lending. However, investors are taking profits as of right now, which is probably a good idea.

Frankly, there is not much good news in the high yield arena other than spectacular returns over the past few months. What is not being talked about is the default rate of these riskier securities which has dwarfed last year’s default rate. High yield defaults are expected to continue well into next year, but currently sit at 12%. Leveraged-loans, on the other hand, are at a default rate of 8.4%, but that may change as more pressure is put on these loans by a weak economy.

It would make sense to take profits from this more speculative sector at this time. You have, basically, bonds making a move of almost 40% in just a few months, which is unbelievable, and before we have any real recovery. In other words, all of the good news is more than likely built into this segment and there is probably more risk than reward at this point in time. With default rates expected to climb to some 14% next year, it would be advisable to examine your exposure and, definitely, take some profits.

In the recent news we had Readers Digest file for bankruptcy which was part of this leveraged loan index. While Readers Digest is more of an old school periodical it did have major name recognition and just goes to show you that no company is immune to default and there is significant risk with these types of investments. The leveraged-loan and high yield business are pretty close to the same animal and correlations can be made between the two.

Some firms are also extending their maturity which is a sign that companies do not have the cash flow to redeem their bonds. If they do not have the cash flow to redeem bonds and they are extending maturities then it is definitely time to reduce your position or exit the sector before the downside begins to appear. After all, what goes up 40% can very easily come down 40% and with default rates climbing the risk/reward is getting much smaller by the minute.