The quality of protections built into the terms of North American leveraged loans weakened to their worst-ever level in the third quarter, Moody’s Investors Service said on Thursday, warning that the move is exposing investors to higher levels of risk.
Leveraged loans, or loans to more speculative borrowers, those that do not have investment-grade ratings, are used to finance private-equity transactions, or M&A deals, or to refinance existing debt or recapitalize a balance sheet. They usually come with floating interest rates, which means when rates go up in the broader market, those rates rise too.
Moody’s said its Loan Covenant Quality Indicator rose to a record 4.16 in the quarter, breaking the previous record of 4.10 hit in the third quarter of 2018 and again in the second quarter of 2018.
The indicator measures the degree of overall investor protection in the covenant packages of speculative-grade leveraged loans issued in the U.S. and Canada on a two-quarter rolling basis. It uses a 1-to-5 scale in which 1.0 shows the highest possible investor protections and 5.0 shows the weakest.
“Weak covenant protections persist as demand for leveraged loans continues to surpass that for high-yield bonds,” Derek Gluckman, a Moody’s VP-senior covenant officer wrote in a note. “Strong demand allows borrowers to negotiate highly flexible covenant provisions, a trend we expect to continue and to leave investors exposed to greater risks than ever before.”
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Existing loans are now in uncharted territory, said Gluckman. If broad market conditions deteriorate, provisions that threaten control of collateral, guarantees and lien priority may become difficult to negotiate for investors in troubled credits. With fewer protections, loans are more likely to end up in default.
Concerns about loose standards in leveraged loans have been building for some time as regulators, including the Federal Reserve, fret about deals with increasing leverage, weaker capital structures and looser credit agreements. The Office of the Comptroller of the Currency said in December in its Semiannual Risk Perspective report that increasing competition from nonbanks for loan originations can “stress banks’ willingness to maintain credit discipline”.
“Abundant investor liquidity is fueling demand and driving eased underwriting and risk layering in new commercial loans, most notably in C&I lending and leveraged loans,” the report found. “Also, there is increasing concern that strong loan performance is masking the accumulated risk in loan portfolios from successive years of eased underwriting and low interest rates, as well as contributing to greater complacency in risk assessment.”
Nancy Davis, the chief investment officer and founder of advisory firm Quadratic Capital, who is credited with predicting last year’s stock market volatility blowup, told MarketWatch in early January that leveraged loans are “definitely bubblicious” and may be contributing to market volatility.
The leveraged-loan market has ballooned in the last two years, surging way beyond levels seen in the 2007-2008 financial crisis. The market hit a record of $1.66 trillion in 2017 and stood at $1.46 trillion in 2018, according to data from Dealogic.
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Even former Federal Reserve Chairwoman Janet Yellen has weighed in on the issue, worrying about the risks for investors of a spate of defaults, bankruptcies and distressed debt in December.
Moody’s said the volume of leveraged loan debt it rates outpaced high-yield bond debt throughout 2018. In December, when markets were highly volatile, there were no high-yield deals at all, but loans continued to clear the market.
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Banks who hold these loans on their books are at risk, but so are investors such as pension funds, insurance companies and asset managers, because they buy the loans in the form of collateralized loan obligations, which contain high levels of leveraged loans and offer better returns than other instruments in the current low-interest rate environment.
Moody’s said it expects the current trend to persist through 2019. The agency said it is seeing weaker protections in nearly every risk category that it tracks.
“While it remains to be seen how Q4 scores will affect these measures, it is clear that existing loans are in uncharted territory in terms of covenant weakness,” said Gluckman. “The breadth and depth of this weakness poses risks never before faced by leveraged loan investors, and outcomes under these extreme conditions have never been fully tested through a full market cycle.”
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