The leveraged loan bubble

Lenders are writing cheques for highly indebted companies at record rates. What could possibly go wrong?

923_Strategy

Ever since US subprime mortgage loans triggered the 2008 financial crisis, eyes have been trained on the debt markets, hunting for the next obscure credit product that could topple the financial system. The latest candidate in the spotlight is the leveraged loan market. What are they, and should we be worried?

Leveraged loans are, as Simon MacAdam of Capital Economics puts it, "syndicated" (ie, the money is arranged by more than one bank); "floating-rate" (ie the interest rate is not fixed, but goes up or down with prevailing rates); "non-investment grade" (ie, on the riskier end of the spectrum); "commercial loans" (ie, loans to companies rather than governments). Roughly $1.3trn in leveraged loans is currently outstanding, according to International Monetary Fund researchers Tobias Adrian, Fabio Natalucci, and Thomas Piontek. Writing on the IMF blog they note that new issuance of these loans hit a record $788bn last year. The previous high came (surprise, surprise) in 2007.

One reason leveraged loans have become so popular is that investors have been happy to buy debt with floating rates, due to expectations of rising central bank interest rates. Yet as lenders have competed to meet demand for the loans, lending standards have fallen. Not only are lenders giving money to companies that are far more indebted and riskier than those they loaned money to in the past, the loans also have fewer strings attached ("covenants" see chart). For example, a borrower might once have had to agree to maintain a certain minimum interest coverage ratio (see our financial glossary for more).

"Lenders are lending money with far fewer strings attached"

Yet such lender protections have virtually vanished. In the US, notes MacAdam, "covenant-lite" loans accounted for roughly 25% of leveraged loans in 2007, to a record high of 80% now. As a result, when loans go bad, recovery rates (the amount the lender gets back if a company defaults) have fallen to just 69% compared with a pre-crisis average of 82%. On top of this, about half the loans have been parcelled up, subprime mortgage-style, into Collateralised Loan Obligations (CLO) and sold to institutions. "Institutional ownership makes it harder for banking regulators to address potential risk to the financial system if things go wrong," warn the IMF researchers.

Should we be worried? Not necessarily, reckons MacAdam. The big difference between now and 2008 is that banks are better capitalised and far less exposed to securitised loans than in 2007. That said, it's worth keeping an eye on the most exposed sectors for signs of trouble brewing notably the energy industry, where the sliding oil price has sent yields on oil company bonds surging.

Recommended

The FTSE 100 has clawed back above 7,000 – how much higher can it go?
UK stockmarkets

The FTSE 100 has clawed back above 7,000 – how much higher can it go?

The FTSE 100 index has risen to over 7,000 for the first time in over a year – it now sits just above where it was in 1999. But its era of neglect cou…
19 Apr 2021
The MoneyWeek Podcast: how to not lose money to inflation and financial repression
Investment strategy

The MoneyWeek Podcast: how to not lose money to inflation and financial repression

Merryn talks to Peter Spiller of the Capital Gearing Trust about how he navigated the last extraordinary year; what he's buying now; and how he plans …
16 Apr 2021
Why you should expect another stockmarket crash
Stockmarkets

Why you should expect another stockmarket crash

Many fear inflation, but a deflationary debt collapse is a more likely scenario in the near term, says Tim Lee
16 Apr 2021
World's biggest fraudster Bernie Madoff has died – what was his scam?
Investment strategy

World's biggest fraudster Bernie Madoff has died – what was his scam?

Bernie Madoff, perpetrator of the world's biggest Ponzi scheme, has died in prison at the age of 82. Matthew Partridge looks at his massive fraud sche…
14 Apr 2021

Most Popular

Lab-grown meat: how “moo’s law” will drive innovation
Soft commodities

Lab-grown meat: how “moo’s law” will drive innovation

Jim Mellon and Anthony Chow, co-founders of Aim-listed Agronomics, explain why they believe that “cellular agriculture” will benefit from massive long…
16 Apr 2021
The bitcoin bubble will burst: here’s how to play it
Bitcoin

The bitcoin bubble will burst: here’s how to play it

The cryptocurrency’s price has soared far beyond its fundamentals, says Matthew Partridge. Here, he looks at how to short bitcoin.
12 Apr 2021
Lab-grown meat: the new agricultural revolution
Soft commodities

Lab-grown meat: the new agricultural revolution

Vegan alternatives are taking off, but the future of food technology lies in lab-grown meat – cultivating steaks and burgers from animal cells, says A…
16 Apr 2021