Warnings mount for the leveraged loan market

At most recent meeting of the Federal Open Market Committee in September, Federal Reserve officials debated the usual topics. Is inflation heating up? How tight is the labor market? And of course, what is the future path of interest rates? This time around, however, policymakers have also raised concerns about something else: leveraged loans.

This was not the first meeting minutes in which Fed officials have spent time talking about leveraged loans, those given to highly indebted businesses and individuals at variable rates. In August and June, the Fed mentioned that emissions were picking up. It was the first time, however, that the Fed flagged leveraged loans as a potential risk to financial stability.

The warning comes at a time when several international agencies and organizations have issued their own take on the booming $1 billion+ leveraged loan market. This weekthe Bank of England (BoE) drew a parallel with the growth in subprime mortgages in 2006 that triggered the global financial crisis. Earlier this month, the IMF has warned of the breakneck pace of leveraged lending, which has been largely driven by non-banks, and the slipping standards of many of these loans. And in September, the Bank for International Settlements (BIS) reported the global boom and deteriorating credit quality, also potential risks.

Let’s start with the first concern.

In just six years, outstanding leveraged loans in the United States have doubled to $1.1 billion, according to S&P Global Market Intelligence’s LCD. Europe’s share is smaller, but it is also growing rapidly. As a share of new corporate issuance in the United States, highly leveraged loan transactions – where debt is at least 5 times EBITDA – account for around half, surpassing levels seen before the financial crisis . In Europe, the ratio is even higher, at around 60%. Here’s a chart from the IMF’s Financial Stability Report released earlier this month, which shows the growing dominance of leveraged lending:

The UK, in particular, has seen a dramatic increase. According to the BoE, gross issuance of leveraged loans hit a record high of £38bn in 2017, with an additional £30bn issued so far this year. Combined with high yield bonds, the stock of UK corporate subprime loans has more than doubled since the crisis, according to the BoE:

To put this into context, the leveraged lending boom comes at a time when governments, non-financial businesses and households around the world are awash in debt. Since the global financial crisis, which ushered in nearly a decade of quantitative easing and ultra-low borrowing costs, the non-financial sector in advanced and emerging market economies has fallen by about $150 billion in the Red. This represents approximately 250% of GDP. Here is another chart from the same IMF report showing the rise:

Now onto the second concern.

Most of these loans are now covenant-lite, meaning borrowers face fewer restrictions on collateral, payment or income level. Lenders, therefore, have much less protection. According to ratings agency Moody’s, about 80% of US leveraged loans in the first quarter were considered covenant-lite, up from less than 25% in 2006 and 2007.

To assess the quality of commitment, Moody’s tracks many metrics, including debt requirements and the age of lenders’ receivables, then rates the average strength on a scale of 1 to 5. The higher the number, the lower the commitment. The indicator is now at 4.12, the lowest ever recorded:

Worse still, many of these leveraged loans are bundled into Collateralized Loan Obligations (CLOs) to be bought and sold by investors. Mutual funds have become major buyers of these instruments, and when the unwinding comes – as is almost certain – here’s how the BIS thinks it could play out:

Mark-to-market losses could spur fund redemptions, induce sell-offs and drive prices further down. This dynamic can affect not only the investors holding these loans, but also the broader economy by blocking the flow of funds to the leveraged credit market.”

According to the Fed, this most certainly looks like a risk to financial stability.

Priscilla C. Carnegie