Leveraged loans: expect a bloodbath

The European leveraged-loan market could turn into a “bloodbath” if the credit cycle turns, say Joshua Galaun and Willem Sels of Dresdner Kleinwort. Thanks to the surge in debt-financed buyouts, the volume of leveraged loans has reached record levels.

By Cris Sholto Heaton

published 3 November 2006

in Features

The European leveraged-loan market could turn into a "bloodbath" if the credit cycle turns, say Joshua Galaun and Willem Sels of Dresdner Kleinwort. Thanks to the surge in debt-financed buyouts, the volume of leveraged loans higher-risk loans on which the borrower must pay higher-than-usual rates of interest rose 135% year-on-year in 2005 and looks set to beat that record this year. At present, default rates remain low and there's no shortage of buyers for this debt, but as soon as some borrowers start to struggle, things could get ugly.

Many borrowers "may find that some of their lenders are in fact hedge funds with different agendas to lending banks", say Galaun and Sels. Rather than sticking around to help the troubled firms regroup, these investors will want to bail out as soon as possible. And businesses that are teetering on the brink of default and desperately need more finance to keep going may find that the current pool of liquidity evaporates very quickly.

One observer who clearly agrees is Jon Moulton of private-equity firm Alchemy, which has recently set up a £300m fund to buy the debt of firms close to collapse but that could be turned around. "We're looking at an overheated market right now," Moulton tells Maggie Lee in The Independent on Sunday, "and we'll see some spectacular falls in the next year or two. It's just a matter of time." He expects to see e30bn of leveraged loans defaulting every year. This will create a huge market for distressed debt investors "comparable in size to the total funds raised by the UK [investment] industry last year".

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Cris Sholt Heaton is the contributing editor for MoneyWeek.

He is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is experienced in covering international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers.

He often writes about Asian equities, international income and global asset allocation.