Getting Toppy In Leveraged Loans

One of the greatest investing opportunities that emerged during the height of the credit meltdown in Q4 2008 was the implosion of the leverage loan market. While individual investors can’t access individual loans (since they usually trade in million dollar increments), several closed end funds issued by the big bond managers exist that exclusively comprise these floating rate bank loans.


One that caught my eye in late 2008 was the Blackrock Floating Rate Income Strategies Fund (FRA). While I have traditionally shied away from investing in open or closed end mutual funds, a few things really made closed end funds extremely attractive during the late 2008 timeframe. Firstly, bank loans were trading at 60 cents on the dollar. While individual security selection may have yielded better results, as an individual investor I didn’t have the capital to buy into this market. Buying a basket of high quality bank loans at 60 cents on the dollar seemed good enough.

Secondly, and more importantly in my opinion, an exodus from risky assets, drove the valuations on closed end funds to double digit discounts to net asset value (NAV). In fact, in November 2008, when I began to build a position in FRA, the fund was trading at a remarkable 20% discount to its NAV. Assuming the average security in the portfolio was trading at 60 cents on the dollar, I was able to purchase a basket of secured bank loans at 48 cents on the dollar!

While the credit meltdown left much to be concerned about, bank loan recoveries in bankruptcy have averaged in excess of 80 cents. As such, I felt my margin of safety was sufficiently wide, even under the most dreadful of circumstances. Add in a current dividend yield of 18% paying monthly distributions and I considered FRA a once in a lifetime opportunity.

So what happened? From a purchase price of approximately $8.50, FRA last traded at $16.35 for a 105% gain. Throw in $1.52 of cumulative dividends received since December 2008 for an additional 18% of income, and the total return equates to 123%.

While the appreciation in a reasonably safe security has been remarkable, all good things must come to an end. From a nadir of 60 cents on the dollar, the average bank loan now trades in excess of 90% of its face value. Even more concerning, FRA’s 20% discount to NAV has now turned into a 14% premium. As such, by buying FRA one is buying a portfolio of bank loans in excess of par. While a rebound in LIBOR could validate this premium (since bank loans typically pay interest that is indexed to 3 month LIBOR), I am always concerned when closed end funds trade at a premium to par. This is particularly the case with FRA given the spike relative to its NAV has only occurred within the last few weeks (see chart below).

As suggested in prior posts, the easy money in credit has unquestionably been made. While I will concede that I may be early, I strongly believe that the credit markets have crossed over from being incredibly undervalued in Q4 2008 to reasonably valued in Q2 & Q3 of 2009 to firmly overvalued as we exit Q1 2010. New issue deals oversubscribed by 5-6 times, closed end bond funds trading at double digit premiums to NAV, tens of billion of dollars of monthly inflows into credit funds (i.e. performance chasing), compression of spreads to well below pre-Lehman levels, and growing concerns about inflation, have all heightened my cautious view on the credit markets. Perhaps we get another 150-200 points of spread compression (implying 12-15% of upside on the average high yield bond), but too many uncertainties exist for investors to hold out for this last bit of upside.