It has been a feeding frenzy for junk debt. Yield-desperate investors, driven to near insanity by the Fed’s strenuous interest-rate repression, are holding their noses and closing their eyes, and they’re bending down deep into the barrel and scrape up even the crappiest and riskiest paper just to get that little extra yield.
Last year, highly leveraged companies issued $1.1 trillion in junk-rated loans. It’s a white-hot market. Leveraged-loan mutual funds – dolled up in conservative-sounding names and nice charts to seduce retail investors – gorge on these loans. They saw 95 weeks in a row of inflows, week after week, without fail, adding over $70 billion to their heft, as Bloomberg reported, and only the sky seemed to be the limit. But suddenly, that endless flow of money reversed.
“It’s going to be a disaster on the way out,” Mirko Mikelic, who helps manage $7 billion in assets at ClearArc Capital, told Bloomberg. “On the way in, there’s insatiable demand….”
Private equity firms have been ruthlessly taking advantage of that “insatiable demand.” And they have a special self-serving trick up their sleeve: Their junk-rated overleveraged portfolio companies issue new loans, but instead of using the funds for expansion projects or other productive uses, they hand them out through the back door as special dividends. It’s one of the simplest ways PE firms use to strip cash out of their portfolio companies. It loads even more debt on the already highly leveraged portfolio company without adding productive capacity. And those who end up holding this debt – for example, the mutual fund in your portfolio – have a good chance of losing it all.
“It’s kind of like an epidemic,” explained Martin Fridson, a money manager at Lehmann, Livian, Fridson Advisors LLC, in an interview with Bloomberg. “Once an investment banker sees that, he’s going to go to his clients and say, ‘Here’s a window of opportunity, you can take a dividend and get away with it.’”