JP Morgan’s Michael Cembalest says the leveraged loan market is “deeply concerning” right now

JP Morgan

Michel Cembalest

  • In Europe, 95% of all leveraged loans are now ‘cov-lite’, meaning companies have made little or no promises to investors about how they will get their money back. Overall, it’s over 80%.
  • “It concerns me deeply to see the erosion of the alliance that’s happening here,” JP Morgan’s Michael Cembalest told Business Insider.
  • “The leveraged loan market is one of those markets that is very liquid when everybody wants it but really illiquid when nobody wants it,” Cembalest said. “In bad markets, liquidity goes down.”
  • Read more Business Insider Prime stories here.

JP Morgan’s Michael Cembalest describes himself as a financial traditionalist. “I grew up on a fixed income,” he says, referring to one of the less exotic areas of banking.

But what’s happening in the world of leveraged lending right now scared him. It’s “deeply concerning,” he told Business Insider. As the market expands — the size of deals closed in 2019 hit an all-time high since 2007 — the quality of that credit has never been worse.

Leveraged loans are money lent to businesses at relatively high interest rates. They are considered one of the riskiest types of commercial debt because companies that incur them often do so as part of a turnaround or private equity buyout. Leveraged loans are often referred to as “junk” debt.

Cembalest recently dedicated one of its “Eye on the Market” notes to the sad state of poor quality non-financial corporate lending. “I knew there had been a deterioration in loan coverage,” he said. But “when I sat down and put pen to paper, I was very disappointed.”

“It’s deeply concerning to me when you see the erosion of the alliance that’s happening here.”

Those words should make your hair stand on end, given that Cembalest is the chairman of market and investment strategy at JP Morgan Asset Management, which has $2 trillion in assets under management.

in Europe, 95% of all leveraged loans are now ‘cov-lite’, meaning companies have made few promises to investors about how they will get their money back

“Covenants” are trading terms that provide protections for investors who lend money. These protections could include superiority in the order in which a company repays its debt, or a prohibition on the company taking on new debt.

But data from S&P Global Market Intelligence’s Leveraged Commentary & Data unit shows that in Europe, 95% of all leveraged loans are now “cov-lite”, meaning companies have done little or no promises to investors on how they get their money back. “Cov-lite” loans are even riskier than conventional leveraged loans, which were already at “junk” status.

In cov-lite loans, “even defaulting companies can now make restricted payments, pay junior debt subordinated to you, or pay new debt”, he said on his podcast. In the cov-lite universe, companies artificially inflate profits with one-time add-ons of non-recurring expenses, “assumed synergies” and other non-standard cost savings, he said. Wedding rings prevent this kind of chicanery. Cov-lite loans are not protected against such behavior.

leveraged loans

S&P Global Market Intelligence leveraged commentary and data

“The foundation of the Anglo-Saxon banking principle is ‘sound lending and fair commitments,'” Cembalest said. “It’s not what it is.”

“We’re in the part of the cycle where there’s a lot of risk taking,” he told Business Insider.

The United States is a less risky place than Europe, but only slightly, according to S&P. Globally, cov-lite loans are just over 80% of the market right now.

leveraged loans

S&P Global Market Intelligence leveraged commentary and data

The magnitude of this risk can be seen in this next chart of trade sizes for US leveraged buyouts. Although the total amount of loans issued stabilized in 2019 compared to the peak in 2018, the size of individual transactions increased.

The average transaction now exceeds just over $2 billion, a record not seen since just before the 2007-2008 financial crisis.

leveraged loans

S&P Global Market Intelligence leveraged commentary and data

The increasing size of trades has gone hand in hand with the increasing extent of leverage taken.

This chart shows the percentage of all deals involving companies that have borrowed more than six times their revenue – the largest loans in the market relative to company size. Ten years ago, taking out a loan six or seven times the amount of your profits was a rarity. Today, 40% of the entire leveraged loan market looks like this, according to S&P.

lev loans with hi:ebit debt

S&P Global Market Intelligence|Comments and data mined

In the broader market, the average ratio of all leveraged buyout debt to earnings now stands at 5.9x. Historically, regulators frowned on anything over 6X but Trump administration officials recently told the market that the 6X ratio is now seen as guidance, not a rule..

leveraged loans

S&P Global Market Intelligence|Comments and data mined

The market is driven by low central bank interest rates, Cembalest believes. With cash and bonds paying insignificant interest rates, “nothing has been left to chance in the world for people to get a return,” he said. The result is that leveraged loans have evolved from the type of specialized investment that only a sophisticated institutional investor would hold, to a product that has worked its way into consumer assets.

“In bad markets, liquidity decreases”

There is not much transparency on who owns what. But Cembalest is concerned about the appearance of leveraged loans in unexpected portfolios, such as mutual funds, SEC-approved vehicles, public pension plans, insurance companies, hedge funds. , private credit funds, college tuition funds and endowments, Japanese or Latin American pension plans. offshore funds. Managers at these types of institutions are under pressure to show results – so the return on leveraged loans must be attractive.

The lack of transparency means that it is difficult to assess the relative liquidity, or illiquidity, of the market.

“The leveraged loan market is one of those markets that is very liquid when everybody wants it but really illiquid when nobody wants it,” Cembalest said. “In bad markets, liquidity goes down.”

There are, however, two pieces of good news.

First, Cembalest does not believe the leveraged loan market is large enough to implode as the mortgage market did during the 2007-2008 financial crisis, although he believes the leverage used is “similar in principle”.

And second, although the market price of loans collapsed by 30% in 2009 during the crisis, the actual losses realized for those who held them were probably less than 10%, estimates JP Morgan. “It took 6 months before prices accurately reflected the losses incurred,” Cembalest said.

JP Morgan

JP Morgan

Priscilla C. Carnegie