The Wicked Winds of High Leverage, Low Rates & Weak Covenants

In our Chart for the Curious (CFTC) last week, we showed that levels of risky debt had hit 2000 peak levels once again. Investopedia’s definition states that “debt/ebitda measures a company’s ability to pay off its incurred debt.” In our CFTC, we agreed with Buffett’s view that the use of this metric of solvency is a mistake.

Buying Stocks with Debt

In Abby Latour’s excellent piece “Leveraged loans fuel Q2 LBOs at fastest pace since global financial crisis” she observes the following:

  • Corporate buyouts in Q2 2021 had the largest syndicated leveraged loan volume since the GFC
  • Loan volume in H1 2021 exceeded all of 2020
  • Private credit may have become a principal source of deal lending

“…the cost of raising funds in the leveraged loan market…is at the lowest point since the global financial crisis…The borrowing cost of LBO-related loans issued this year stood at roughly 4.7%…” KCR reminds readers that CPI is north of 5%. There does not appear to be a Margin of Safety in yields like this.

All in Spread of Institutional Loans Backing US LBOs Hit Record Lows

White & Case summarizes the explosion in demand and issuance. “…Borrowers jumped at the chance to take advantage of the favorable terms and pricing…”[1] The piece also notes that two senior government officials will likely bring more focus to credit ratings and ratios measuring firms’ ability to pay off its debts.

Janet Yellen is Treasury Secretary and Maxine Waters regained the chair of the House Financial Service Committee. The article notes that “Both figures will want to see leveraged finance markets regulated more closely during their terms.” Borrowing money and loading balance sheets with debt may become the path to unwanted regulatory attention.

White & Case closes with the stunning chart below. Never before have investors lent so much at such low rates with such poor protections. As our piece explaining what high volume means in stocks showed, these weak protections are often matched in public markets by reckless speculation.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

[1] Emphasis on terms is ours

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

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October 20, 2021 |

Categories: Quick Takes

October 20, 2021

Categories: Quick Takes

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