Are all private markets slowly being eclipsed? Private equity shops are buying up public companies faster than ever, with today’s KKR-First Data deal being only the latest. But it’s not only equities which are moving into the privately-owned twilight: it’s debt, too:
Three-quarters of loans to junk-rated US companies are now provided by hedge funds and other non-banks, according to a new report on the US leveraged loan market…
Non-bank lenders owned $400bn of leveraged loans at the end of last year — 10 times the amount a decade ago, and equivalent to about two-thirds of the high-yield bond market.
If the recent steep growth of the leveraged loan market continues, it could overtake the high-yield bond market by 2009, S&P LCD reckons.
In other words, junk bonds are rapidly becoming a thing of the past. Today, it’s all about junk loans — illiquid instruments which hedge-funds hedge in the equally opaque and non-public CDS market. The good news, insofar as there is any, is that if and when a lot of these loans go sour, the impact on the banking system will be much lower than the volume of loans would imply. But the bad news is that ever-larger chunks of corporate balance sheets are now completely unregulated.
I’m not sure that it’s fair to call leveraged/institutional/B loans illiquid. They trade much more frequently than bank loans, though less than, say, Peruvian government debt. But investment banks do make markets in these loans, and they are, potentially, held as collateral for prime lending. What hedge funds (and money market accounts, which have an even bigger presence in this market) do with these assets is the big question. They may hedge them in the CDS market, which is horribly illiquid for the less well-known names. They may trade in and out of the debt furiously, or (less likely), try and fashion a crude hedge out of assets that correlate.
If you are increasing the open interest in CDSs on a company while decreasing the amount of debt securities it has outstanding — say, for use as a reference obligation — those CDSs had better be cash-settled in some manner. Or are the loans sufficiently transferable to be used as reference obligations themselves?