Leveraged Loans Pose Risk

The Bank for International Settlements continues to sound the alarm surrounding corporate debt. Per an article in the FT, “mutual funds that invest in investment-grade debt have increased their share of triple B bonds to about 45 percent of portfolios in the US and Europe, from 20 percent in 2010.” Triple B debt is the lowest rating that qualifies for investment grade. The concern is that if enough issuers were abruptly downgraded it would create a corporate debt fire sale.

The sheer volume of increasingly cov-lite leveraged loans being repackaged and sold as CLOs is starting to raise concern in a rising rate environment. Approximately 50% of corporate debt issuance in the US is now in the form of highly leveraged loans (defined as 5.0x EBITDA). There are also a growing number of mutual funds and ETFs that purchase these loans, which makes the exposure difficult to track (bank loan funds have tripled since 2008).

The article has an ominous conclusion, citing how the Bank of International Settlements believes it will all unfold:

“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.”

Central bankers are focusing on the threat posed by the growing market for leveraged loans, which recently totaled $1.3 trillion. According to LCD, issuance is on pace to exceed last year’s record of $650 billion. Losses could be substantial should borrowers default on these cov-lite loans:

“Moody’s projects that top-ranked ‘first lien’ loans will recover 61 cents on the dollar when borrowers default. That is down from a historical average of 77 cents. The drop-off is even larger for subordinate ‘second lien’ loans, with recovery rates of just 14 cents on the dollar, as opposed to the 43 cents historical average.”

See article for some excellent charts detailing cov-lite growth in this space.