• June 3, 2023

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As Warren Buffett says, “Only when the tide goes out do you discover who’s been swimming naked.” Now that the tide is receding as fast as it ever does, the list of exposed asset classes is getting long: meme stocks, speculative tech stocks, crypto, NFTs, and so on.

Not since the dotcom bust of 2000 (or even the Tulipomania crash of the 17th century) has the tide reversed so quickly and so powerfully. This particular psychological reversal was brought about by the Fed interest rate hikes, but it could have been anything in the end: the laws of economics can be temporarily suspended but never repealed. Asset prices have to revert to intrinsic value eventually. Where there’s little or no intrinsic value to begin with (i.e. Cryptocurrency Luna
), the tides can be unforgiving.

Which brings us to some literal junk which remains remarkably unexposed in a world of naked swimmers. It’s not called junk by the public who sells it or buys it, of course. In the parlance of Wall Street, they’re called “leveraged loans” or “floating rate loans” —euphemisms which slyly gloss over the real risk involved. These are typically the obligations of companies with junk balance sheets (rated lower than BBB) that have adjustable interest rates.


Sold to investors as hedges against higher rates, these loans did well in 2021, up over 5%. Given that when rates rise, the interest received by the loan holders rises too, the loans looked like nirvana to anyone who needed interest income in a raising rate environment. In contrast, conventional fixed rate bonds lose value when rates rise, a fact all too real for bond investors in 2022.

This year, floating rate loans have suffered mildly, down 4%. But why have they lost money at all if they’re hedges against rising rates? The answer lies in the enormous credit risk these loans contain. As the obligations of over-leveraged companies, they’re dangerous to begin with. The paradox is that as rates rise, these companies see their interest payments increase, causing further problems. Only debtors that need cash desperately would ever make this Faustian bargain: any corporation with good credit would have locked in the recent sixty-year lows in interest rates, not gambled with an adjustable rate loan.

Given what’s likely to happen next, it’s not too late to sell this junk asset class. The losses thus far have been minor relative to other things. If we enter a recession, these floating rate loans will bear two simultaneous burdens: rising interest payments along with collapsing revenues. That’s a classic recipe for bankruptcy.

Floating rate loans are often promoted for their “seniority” in the capital structure: the fact that they get paid before other corporate liabilities in liquidation. Don’t let this fool you into complacency. The recovery rates are not high enough to make up for the risk taken.

Beware the receding tide: there’s still a surprise or two lurking.


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