At first glance, leveraged loans are a tautology. These are simply loans, usually arranged by a syndicate of banks, to companies that already owe a lot. Most are issued in America and then grouped together in “secured loan bonds,” legal entities run by private equity firms, hedge funds, and the like, which slice up the loans and distribute them among their investors based on their taste for risk. According to S&P Global Market Intelligence, a data provider, more than a third of leveraged loans refinance existing debt. Much of it is used to fund mergers and takeovers. Some pay dividends to private equity firms.
The leveraged loan market has grown rapidly in recent years. S&P Global Market Intelligence estimates that more than $ 1.4 billion was in circulation at the end of last year, twice as much as in 2011 (see chart). In 2018, $ 736 billion was issued, slightly less than the record for 2017. (Some estimates say the market is even bigger.) Lenders have been enthusiastic because leveraged loans have offered returns. decent when interest rates have been ultra-low; because most are variable rate, they pay more when rates go up. They are generally guaranteed, which gives a certain comfort in the event of default of the borrowers. Borrowers like leveraged loans because they are more flexible than bonds. For example, they are easy to prepay. The abundance of credit has been accompanied by a decline in credit criteria. Most loans these days have few or no “contracts” that would require borrowers to meet specified financial terms in order to protect lenders in the event of a problem.
In recent months, warnings that the market may be heading for trouble have multiplied. In April 2018, the IMF detected features “reminiscent of past episodes of investor excess”. Janet Yellen, former head of the Federal Reserve, and Daniel Tarullo, former governor of the Fed, also sounded the alarm. This week, Henry McVey, head of asset allocation at KKR, a large private equity firm, recommended investors reduce their exposure.
Two concerns stand out. One is the risk of default. Slower growth and rising US interest rates could hurt borrowers’ ability to repay and the value of collateral. The absence of covenants makes investors even more vulnerable. Moody’s, a rating agency, estimates that investors could recover 61 cents on the dollar if borrowers default, compared to a long-term average of 77 cents. The second concern is a cycle of falling prices as anxious investors seek their money back. In September, the Bank for International Settlements expressed concern that downgrades of distressed borrowers could trigger a “fire sale.” It’s not happening yet, but some investors seem to be considering the exit: Bloomberg reports that loan prices fell last month.