Leverage is Back in the Credit Markets

Last night I had dinner with a friend who works as a bank loan trader for a large and distinguished credit-focused hedge fund. We were chatting about the wild ride the credit market has taken over the last two years and commiserating how difficult it will be to make money in 2010 given how much spreads have narrowed since the depths of the market swoon last December.

In casually noting how difficult it is to get excited about bank debt trading at close to par (vs. 40-60% of par one year ago) with skimpy spreads and LIBOR close to zero, my friend told me his fund is now employing what is called a Total Return Swap (“TRS”) to juice their returns. Essentially, a TRS is a form of financing provided by an investment bank that allows an investor to lever their returns (i.e. if a security is trading at 80 cents on the dollar a hedge fund could finance some portion of this purchase to turn a low return investment into one with a mid to upper teen yield).

At the height of the credit bubble in 2007, levered purchases of bank debt were fairly common and contributed to the madness. However, this mountain of leverage came crashing down in 2008 when the trading levels of most securities fell below the face value of the debt issued to finance their purchase (akin to the price of a home falling substantially below the value of its mortgage).

As my very crude example below demonstrates, the use of a TRS can help juice a security with an otherwise paltry 5% current yield into a highly attractive 15% clipper (admittedly, the use of 80% leverage is probably high, but certainly existed at the height of the credit bubble). Since my firm never employs leverage in any of our purchases, much of the bank loan market has now been rendered off-limits to us.

Should liquidity in the credit markets remain robust and the economy continue to heal, many of these investments will pay off handsomely. However, it’s quite disconcerting to me that not only is leverage quickly coming back into the system, but that it is the leveraged buyer is who driving the sharp rebound in asset prices. Does the memory of investors extend beyond one year or is 2008 sufficiently in the past that we are ready to go back to our old ways?

Another somewhat related point – how perplexing is it that investment banks are willing to lend to hedge funds (who are using the cash to drive asset prices higher), but most Main Street businesses who operate in the real economy still can’t get a loan.