Structural changes in the loan market over the last decade have shifted many loans from the balance sheets of big banks to those of institutional and retail investors. What risks might these loans pose to investors?
The Fed and BIS are among the global authorities that have warned about leveraged loan risks
Consider this investment prospect: lending money to corporations with substantially high levels of debt, and whose credit ratings may stand well below investment grade. The upside? Potentially higher yield, variable interest rates, and some degree of regulatory protections. The downside? A potential for capital loss, likely triggered by loan defaults. Might the prospect be worth the risks?
These instruments are called leveraged loans. Over the last decade, they’ve ballooned into a $1.2 trillion market; $140 billion of it is held in ETFs and mutual funds by retail investors. Despite their potential hazards, these loans have been in high demand.
But as the winds change over the economic landscape, and as warning signs begin to flash yellow, it may be time to consider how the new leveraged loan dynamics might affect, or be affected by, the credit markets. What risks do these loans pose to investors? And what kinds of vulnerabilities might they bring (as noted in the Federal Reserve’s September FOMC minutes) to the broader economy’s financial stability?
Let’s explore these dynamics by asking the following questions:
Leveraged loans are loans extended to corporate borrowers that already have an overburdened debt load. Most of the companies that use them are below investment-grade level or are too small to enter the bond market.
The higher yields that leveraged loans offer typically reflect the risks they pose to the lender. Many also feature floating interest rates, often based on LIBOR (the rate of interest that banks on the London interbank market charge each other for lending capital), which, in addition to the high yield, can make such loans an attractive prospect for lenders and investors.
These are mostly held by banks and institutional investors, but some mutual funds and ETFs will hold them as well. Some leveraged products are available to retail investors through high-yield bond funds but it’s not typical for retail investors to hold them directly because they are quite risky.
So why would a business already piled high in debt add even more? To accomplish any of the following corporate activities: mergers and acquisitions (such as leveraged buyouts); to refinance debt and/or recapitalize their balance sheets (e.g., change their capital structure, buy back stock, pay dividends, repay debt, and so on); obtain working capital; and other, more general purposes.
Why have these loans become so popular among institutional and retail investors? Two of the main features that have attracted investors are floating interest rates and investor protections.
Floating interest rates. Imagine holding a fixed-interest debt security while rates are rising. You might miss out on higher yield, but also, the value of your security might decline, meaning you’d lose money if you were to sell it at face value. Loans offering floating rates adjust their yield quarterly, meaning investors can potentially benefit when interest rates rise.
Investor protections. Initially, lenders were protected by covenants—formal debt agreements that either required borrowers to perform certain activities (affirmative covenants) or limited their capacity to perform certain activities (negative covenants). Any violation of these covenants entitles the lender to ultimately announce default and demand an immediate repayment of principal plus any accrued interest.
These covenants seemed to offer more protection than high-yield corporate bonds. Hence, leveraged loans were perceived as being less risky than, say, junk bonds.
Given these investor protections, why are leveraged loans suddenly considered by some analysts as a potential quagmire? To answer this question, we must examine how the leveraged loan market has evolved and changed over the course of the decade.
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After the financial crisis of 2008, more issuers began shifting into a “covenant-lite” loan structure. Covenant-lite loans, also called “cov-lite,” are borrower-friendly loans that have fewer restrictions than those limited by more traditional covenants. With fewer covenants in place, cov-lite loans can mean more risk for the lender.
Interestingly, most companies that opted for a cov-lite structure over the last decade ended up paying higher interest during a period of low interest rates. (The Fed’s quantitative easing policies artificially lowered rates, which meant some investors were seeking higher yields in more risky investments.) But these companies were also able to obtain a much higher level of financing versus equity to undertake certain capital-intensive endeavors, such as leveraged buyouts.
And therein lies the rub. According to credit rating agency Moody’s, approximately 80% of U.S. leveraged loans held by investors toward the end of 2018 were “covenant-lite.” Compare this with 2006 and 2007, when cov-lite loans made up less than 25%. This means the bulk of this loan market is currently carrying more risk than it has throughout its entire history.
Considering this market’s 80% cov-lite exposure, the bulk of these loans are packaged into “collateralized loan obligations” (CLOs) that are sold to investors. The biggest buyers of these instruments are mutual funds.
Should the leveraged loan market unwind, how might this scenario play out? Here’s a take on the matter from the Bank for International Settlements (BIS). According to its September 2018 BIS Quarterly Review:
Moreover, given that mutual funds are a major buyer, mark-to-market losses could spur fund redemptions, induce fire sales and further depress prices. These dynamics may affect not only investors holding these loans, but also the broader economy by blocking the flow of funds to the leveraged credit market.
The Fed’s take on this emerging risk, as stated in the September 2018 FOMC minutes, may be more subdued, but is nevertheless cautious:
Some participants commented about the continued growth in leveraged loans, the loosening of terms and standards on these loans, or the growth of this activity in the nonbank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability.
So what are we to think of the risks that these loans pose to investors as well as the broader economy?
First off, covenant-lite loans may lead to higher defaults. But these defaults may have less to do with covenant reduction than with the originating loan rating based on overly optimistic cash flows or other exogenous factors.
It’s interesting to note that a whopping 70% of the loans in this market are close to being classified as “extremely speculative.” And although the market might not pose a systemic risk at this point, the risks to the individual investor should be of concern.
Fixed-income investors who carry exposure to leveraged loans might consider looking out for declining corporate performance. When the current economic cycle ends, investors might find that company underperformance may create price volatility, particularly in an illiquid market.
ETFs and mutual funds make it relatively easy for investors to gain broad market exposure. But given certain economic situations, they can become illiquid. And although leveraged loans may have performed strongly over the last few years, they may become exceedingly volatile—while providing fewer protections than other assets—once the current business expansion ends.
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