The fate of $ 1 trillion in risky US loans may be in Japan’s hands

Japanese banks may have clawed back a third of loans made to heavily indebted US companies, propelling the market size beyond $ 1 trillion, according to a new estimate from UBS Group AG.

Years of low returns have prompted investors to invest money in leveraged loans – credits given to companies with weaker balance sheets. These assets were presented as a safe haven for those worried about the prospect of rising interest rates and were often repackaged into secured loan bonds (CLOs) with credit enhancements to protect investors.

Now the worry is that cracks are starting to grow in what was once one of Wall Street’s hottest commodities. A record $ 2.53 billion was withdrawn from leveraged loan funds in the week ending December 12, while Wells Fargo & Co. and Barclays PLC recently took the rare step of pulling out a $ 415 million market deal. Only 0.9% of US loans tracked by Citigroup Inc. are trading above par or face value, up from over 70% just a few months ago.

Japanese banks bought the highest rated AAA CLOs because they have higher yields than sovereign debt of the same rating, according to UBS, with lenders accounting for around 33% of inflows to the asset class in recent years . While demand is vulnerable to a pullback, it should help keep the market stable in the face of a recent sell-off, the bank said.

“Japan’s offer for US loans will not be easily shattered,” analysts led by Stephen Caprio wrote in a study released last week. “Most Japanese banks are buy and hold investors; outright selling will be quite limited unless the prospect of full credit losses becomes probable, which requires a much higher risk of recession than today.

This is an example of a wider trend of Japanese investors looking for returns overseas after facing zero returns at home. Many CLOs have been purchased through what is called repackaging, in which dollar-denominated assets are essentially repackaged in yen using a special-purpose vehicle and a swap agreement. currencies with another bank.

Japanese banks could buy between half and three quarters of AAA-rated CLO tranches, UBS said, citing evidence from clients and an analysis of the currency swap market. Without Japan’s bid for AAA-rated CLO paper, the top-rated CLO spreads would likely widen to return to 2014 levels, 50 basis points wider, the bank estimated.

An indicative Bank of England estimate in November said that “international banks, particularly US and Japanese banks” held a third of the stock of global CLOs, concentrated in less risky tranches.

The size of the leveraged loan market swelled to $ 1.1 trillion, from $ 682 billion in 2014, according to UBS. That’s not far from the $ 1.2 trillion in rotten rated corporate bonds, a market that has also exploded in size thanks to years of low interest rates and yield-hungry investors.

“Leveraged loans have supplanted bad bonds as a riskier credit hotbed,” UBS analysts wrote, calculating that by one measure – debt granted to companies rated a few notches above default. payment – there are now more risky loans outstanding, at $ 794 billion. , that the risky bond debt at $ 750 billion.

Analysts are sounding the alarm bells to varying degrees on the asset class, with JPMorgan Chase & Co. noting that the CLO issue has proven to be more resilient than other types of credit in the face of market volatility. Despite lower aftermarket prices, US CLO sales hit a record $ 127 billion this year, JPM said.

This supply dynamic could work against the market, however, as investors are wary of an economic slowdown alongside the normalization of central bank policy.

“The recent releases are a small fraction of the entries over the previous two years,” Citigroup’s Michael Anderson and Philip Dobrinov wrote in a December 13 memo. “We expect another weakness to come.”

Even Japanese banks can slow their purchases in cases such as an extreme increase in hedging costs or an increase in strain on European lenders involved in repackaging that becomes so severe that it undermines these structures – the counterparty default. being the worst-case scenario, UBS said.

Japanese banks should in theory continue to anchor the market as long as government yields remain low and the Bank of Japan clings to its ultra-relaxed monetary policies, UBS said. But ownership of other types of funds could “amplify the downside,” particularly if investors begin to worry about defaults in the face of a looming recession, analysts wrote.

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