NEW YORK (Reuters) - Corporate borrowers could face a liquidity crisis if lenders insist on tightening covenants as interest rates rise, Michael Vranos, who oversees $6.5 billion at Ellington Management Group, said on Wednesday.
Speaking at the Reuters Global Investment 2018 Outlook Summit, Vranos said he has instead been looking for value in nonperforming loans, reflecting discounts they command, and loans of “fallen angels” rebounding from poor performance.
“I think the next crisis in the market is a crisis of liquidity. I don’t think it’s necessarily a crisis of credit, per se,” he said.
“Think of what salubrious environment corporate borrowers are in right now,” he said. “If they can’t roll (refinance) their debt, it’s going to cost them another 100 basis points, or worse than that, they just can’t lever as much. They put covenants in on that debt. That can crush corporations.”
Many companies, he said, may be ill-prepared for whatever interest rate increases are in store as the U.S. economic expansion approaches its nine-year anniversary.
“It always seems interesting that institutional investors are ill-prepared for big upward rate moves, even if they know it’s happening,” Vranos said.
Vranos founded Old Greenwich, Connecticut-based Ellington in 1994 to benefit from distressed conditions in mortgage-backed securities derivatives, and named it for the Connecticut town where he was raised.
He said the level of U.S. corporate debt has nearly doubled in the last decade, causing “credit creep” even in the investment-grade market, which now houses more debt with “triple-B” ratings, the lowest investment grade.
Instead, he is finding value, and higher yields, farther down the capital structure.
“We’ve been buying first-lien leveraged loans on companies that had in the past had trouble,” such as prior bankruptcy proceedings, Vranos said.
“The leverage is low, maybe 3.5 as opposed to six on these other deals,” he said. “So we’re getting a first-lien on top of the capital structure, rolling off a pretty modestly levered company. We like that. These are yielding in the 8s. That’s a lot.”
Vranos said he also likes small-balance, nonperforming commercial and residential loans.
“They’re sort of credit-risk proof, almost,” he said. “You’re buying properties at a big discount, you’re buying a note at a discount to the property value, and you’re working out the note in a relatively short amount of time.”
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Editing by Jennifer Ablan and Leslie Adler
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