With every passing month, regulators raise fresh concerns about the ballooning market for leveraged loans.
The increased attention around this arcane corner of debt markets have reflected worries that excessive leverage in U.S. corporations could serve as a powder keg and heighten the economic pain from the next recession.
Yet even if such investments don’t upend the U.S. financial system, banking watchdogs including the Federal Reserve say the deterioration of underwriting standards in the leveraged loan market could mean that many holders of leveraged loans will bear losses larger than they had anticipated.
Why are investors worried about leveraged loans?
Leveraged loans are floating-rate loans made to businesses rated below investment grade, often used to finance mergers and private-equity deals. Their growth has been fed by the Fed’s rate-hiking campaign in the past few years, which has lifted the returns of adjustable-rate instruments, and the ongoing demand for richer returning assets against a low-interest-rate environment.
The market for leveraged loans has now ballooned to around $1 trillion, dwarfing its peers in the high-yield-bond universe. Inflows have thinned, however, since the end of last year after the Fed said it would pursue a more cautious approach on additional rate moves at its January meeting.
Taking advantage of the robust demand, underwriters have steadily relaxed investors’ protections in the form of covenants, which can take the form of language prohibiting the firm from exceeding certain levels of leverage or clauses preventing the sale of assets that creditors rely on for collateral.
Ratings firms like Moody’s now say the level of protections offered to leveraged loan buyers have hit a record low. And 80% of leveraged loans fall under the category of covenant-lite, meaning they lack written safeguards for creditors, according to the Bank of International Settlements.
That means if loans begin to default, investors may find the amount they eventually recoup on their beaten-down assets are more meager than they expected. Analysts at Barclays estimated recoveries would fall by around 5 to 10 cents on the dollar in the next downturn, compared with previous episodes of stress in the loans market.
Who buys them?
Before the financial crisis, loans made out to highly indebted businesses were chiefly the preserve of banks. But now leveraged loans are primarily being funded by nonbank lenders such as investment managers and hedge funds, said David Lebovitz, global markets strategist at J.P. Morgan Asset Management, in luncheon held last Wednesday.
See: ‘This will end poorly’, says J.P. Morgan strategist about a boom in arcane debt on Wall Street
In particular, leveraged loans have fed an insatiable hunger among the $600 billion market for collateralized-loan obligations (CLO), data from Securities Industry and Financial Markets Association show.
More than 60% of sub-investment-grade loans have been snapped up by such structured products, according to LCD/S&P, a research consultancy that tracks leveraged lending.
CLOs have also drawn attention in part because of their similar construction to collateralized-debt obligations and other esoteric forms of debt blamed for giving birth to the 2008 recession.
CLO managers bundle and repackage the loans into a pyramid of fixed-interest products, known as tranches, and sell them off to Wall Street money managers. Owners of the bottom layers, such as CLO equity, receive the highest returns but receive the interest payments from the underlying loans last, and are also the first to absorb losses if the loans start to default. Upper layers, like triple-A rated CLO debt, are the most creditworthy, but collect meager returns.
Investors say the appetite for leveraged loans among CLO managers have created a race to the bottom, driving down the quality of underwriting standards and raising the risk that the ultimate holders of leveraged loans will be saddled with deep losses if corporate credit markets sell off.
“Elevated demand for leveraged loans, driven by the increase in institutional investors, notably CLOs, is responsible for the decline in covenant protection,” wrote analysts at Barclays in a Feb. 20 note.
Read: Corporate debt binge carries ‘eerie’ resemblance to subprime lending boom, says Zandi
Are banks at risk?
Former Fed Chairwoman Janet Yellen and some investors say leveraged loans and CLOs are unlikely to provide the source of the next banking crisis, simply because banks are no longer the primary investors nor originators of leveraged loans and collateralized-loan obligations.
Still, regulators are worried their relationships with nonbank players can play out in unpredictable ways.
“Banks are counterparties to these nonbanks in all kinds of transactions,” said Mayra Rodriguez, managing principal at MRV Associates, a consulting firm focused on financial regulatory and risk based supervisory issues, in an interview with MarketWatch.
If the market for collateralized-loan obligations freezes up, banks may struggle to offload their loans in the absence of their biggest buyers. That could weigh on their balance sheets, and potentially crimp lending during times of trouble, according to Dallas Fed President Robert Kaplan in an essay published Tuesday.
Banks also sometimes lend to CLO managers who use the funds to buy leveraged loans that will be later bundled and turned into a newly issued CLO. A sudden fall in loan prices could lead to big losses for banks lending to these “warehouses,” according to International Financing Review.
Mark Mason, Citigroup’s C, +0.80% new chief financial officer and former head of private banking, told analysts in January that the bank had an exposure of around $5 billion to CLO “warehouses.”
Forced selling
The potential scenario of thin trading and panicking mutual funds have also led many to contemplate how a market downturn could create a vicious loop of falling prices and further selling.
“The relative illiquidity of leveraged loans and outflows from mutual funds leading to fire sales could essentially cut the leveraged credit market off from funding, and via this pathway compound the impact on the broader economy,” wrote Marco Stoecke, head of corporate credit research at Commerzbank, in a note dated Feb. 7.
Investors had a small taste of how loan funds would handle sharp outflows after retail investors fled from mutual funds specializing in bank loans at the end of last year. The raft of outflows and sharp price declines saw a benchmark basket for leveraged loans compiled by IHS Markit give up nearly all of its gains for 2018 after sitting on a 4% return at the end of September.
Since January, leveraged loans have bounced back with the rest of the corporate bond market.
What are regulators doing?
For the most part, regulators with oversight over the banking sector, such as the Federal Reserve and the Financial Stability Board, have led the charge in monitoring the risks around leveraged loans.
Randal Quarles, the Fed’s vice chairman for bank supervision and chairman of the FSB, said in an interview with the Financial Times that the FSB would attempt to catalogue the holders of CLOs around the world in order to map out the risks of sharp outflows from their investors.
But Rodriguez say the excessive regulatory focus on banks, the culprits of the last financial crisis, have left the problems building up in the nonbank sector unattended. The International Monetary Fund estimated that nonbank financial institutions‘ assets relative to the U.S. annual economic output jumped to around 160% in 2015 from 40% in the 1980s.
“It’s great that the Financial Stability Board and the Basel Committee on Banking Supervision have focused so much on the banks, because they were at the epicenter of the crisis. But what about the regulation and the supervision of the nonbanks?” she said.
Because nonbanks come in all shapes and sizes, including pension funds, private-equity firms, family offices, hedge funds and fixed-income investment funds, there is no single centralized regulator that has the scope to watch their activities or the power to conduct on-site exams, said Rodriguez.
Also check out: Leveraged loans are in uncharted territory and that’s a big risk, Moody’s says
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