The booming loan market is getting riskier

The leveraged loan market is one segment of the credit markets that thrives in the face of rising interest rates. But the scorching demand for such loans over the past year raises red flags for market analysts.

Leveraged loans are made by loan syndicates to lower quality companies. With a variable interest rate usually pegged to the three-month London Interbank Offered Rate, they offer protection against rising interest rates.

The money is often used to fund mergers and leveraged buyouts – which got off to a good start this year – but not always, as more and more borrowers take advantage of extremely strong demand for such loans.

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“We often see greater demand for loans from investors and borrowers in the second half of the economic cycle,” said John Fraser, head of credit management at Investcorp, which has multiple funds managing more than $5 billion. dollars in the US loan market. It manages an additional $6 billion in the small European market. “With good but not explosive economic growth and the Fed raising rates, this is the ideal environment for the loan market.”

Retail investors like the idea of ​​floating rates and more security than high yield bonds. More than $11 billion has been donated to the 64 bank lending mutual funds so far this year, according to Morningstar data. Total fund assets now exceed $144 billion.

At the end of 2017, there was more than $1.36 trillion in loans outstanding, according to Moody’s research, making the loan market slightly larger than the high-yield bond market.

While strong investor demand has helped leveraged loans post a return of around 2% so far this year compared to a flat total return for high-yield bonds, loan terms have softened. considerably deteriorated in recent years. Many market analysts expect investors in loans made today to suffer significant losses if and when the economy turns and borrowers default on the loans.

“We’ve seen that in the past,” Fraser said. “Whenever the market is strong, conditions become more favorable to borrowers. “Credit risks will increase in the future. In this environment, we tend to say no to aggressive terms,” he added.

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It seems that everyone says “yes” to these terms. Leveraged loans, which are not regulated by the Securities & Exchange Commission, are governed by covenants which stipulate the provisions – if any – that borrowers must follow to safeguard the interests of lenders. They typically involve maintaining interest coverage and leverage ratios, as well as preserving lenders’ position in the company’s capital structure.

One of the main selling points of leveraged loans has been their seniority to bond and equity holders and their reliance on company assets in the event of default. The first lien, however, is no longer what it used to be and lender protection is at an all time low in the market.

“We’ve never seen weaker loan covenants,” said Derek Gluckman, senior covenant manager for Moody’s Investor Services, which provides credit ratings for leveraged loans. This includes before the financial crisis. “While demand continues to be strong, lending terms continue to ease.”

Moody’s now characterizes more than 80% of new loans on the market as so-called “covenant lite” loans. They have no financial maintenance restrictions and they give borrowers a lot of flexibility to issue more debt, pay dividends to shareholders and even withdraw collateral from lenders. “Covenant lite is just the tip of the iceberg,” Gluckman said. “All dispositions are now weaker across all categories.”

In December 2016, J. Crew Group, an apparel retailer owned by private equity firms Texas Pacific Capital Group and Leonard Green & Partners, transferred assets to an unrestricted subsidiary beyond the reach of lenders. Despite legal action by these lenders, the company prevailed thanks to a weak loan covenant.

Private equity owners, known for their aggressive financial engineering, account for about 40% of borrowing in the leveraged loan market. When things go wrong for their businesses, the interests of lenders will not be a priority for them.

So far, few companies have executed J. Crew-style asset transfers, but the flexibility to do so is now being built into more and more loan covenants. “Collateral stripping may not be prevalent, but how many other companies will in a down cycle,” Gluckman said. “The risk is there.”

There are no immediate market concerns. Moody’s expects default rates in the high yield sector to fall from 3.9% at the end of March to 1.7% a year from now, in part because of the increased financial flexibility that weak loan covenants provide to companies. The biggest concern is that when the economy turns and default rates rise, lenders’ recovery rates could be disappointing.

This market is much more opaque than the bond market. There could be some ugly stuff going on below the waterline.

Marc Cortazzo

senior partner of Macro Consulting Group

Historically, investors in leveraged loans have recovered 70 to 80 cents on the dollar in the event of default. This compares to around 60% for senior high yield covered bonds and just over 40% for unsecured bonds. Investors might be reassured by the fact that leveraged loans performed relatively well during the last downturn following the financial crisis. However, Gluckman suggests the next down cycle could be tougher for lenders.

For one thing, the cushion protecting lenders’ principal is smaller, he said. Before the financial crisis, about one-third of the average borrower’s debt was lower than leveraged loans in the financial pecking order. The figure is now around 20%. Borrowers also asked the Federal Reserve to help them out of their hole last time.

“Default rates hit mid-to-high teens, but quickly declined in part due to quantitative easing,” Gluckman said. “There are fears that the next downturn will be longer and more painful.”

For Certified Financial Planner Mark Cortazzo, senior partner at Macro Consulting Group, the weak loan covenants and murky financial statements available on many borrowers are enough to keep him from chasing the returns on leveraged loans. “This market is much more opaque than the bond market,” he said. “There could be some ugly stuff going on below the waterline.”

Cortazzo said investors don’t respect risk in the market and believe the market could turn quickly when sentiment deteriorates. “Think of how quickly things happened in 2008,” he said. “These things tend to go well and then you get hit hard and fast.”

Priscilla C. Carnegie