Leverage loans. The next trigger?

Leverage loans. The next trigger?The leveraged loan market is not immune to slower economic growth

Chandra Roy | The likely catalyst to trigger the widely forecast turn in global stocks is still firmly parked in the ballpark of the US economy, where current general consensus points to a downturn in GDP growth of around 2.5% this year 2019, and close to 2.0% for the next. Not quite recession, at least not for the foreseeable future. Tax cuts accompanied by fiscal stimuli have done well to bolster growth and will likely continue to stoke mild expansion for the time being. The timing of the economic cycle, however, is considerably beyond the tamer stage that statistics report for the European economy, and as the Federal Reserve continues to unwind its balance sheet while still within the scope of rising Fed Funds rates to abate inflation, US corporate treasurers will be finding themselves facing a decline in leverage, an asset class which successfully aided corporate sector expansion since regulation took a stronghold post recent economic crisis.

Leverage loans are made to companies of a risky credit profile, the suitors who have traditionally focussed on the issuance of high yield debt in search of funding. They are later sold on to funds and asset managers, traded wholly as financial products within themselves.

Attention from investors, soared around the start of the present decade partly based on the hierarchy of these products in bankruptcy claims as loans are placed above bonds in the capital structure, guaranteeing preference in repayments above other types of collateral classes in liquidation and judicial suits deeming them safer than purchasing unsecured debt issued taken on board from exactly the same suitor. Further, the rising short term interest rate scenario over the same period assured a more lucrative return on investment in times of historically low yields across asset classes.

Today, at over $1tr, the market is larger than the more traditional high yield bond market, pushing debt suitors into a stronger position in the negotiation rounds, however, thereby reducing investor protection, to worrying levels.

Central bank and other monetary policymakers have raised concerns over systemic risks derived from the proliferation of this market as the asset class generally sits in the hands of private investors who place insufficient controls on investment protocols as would other investment entities, given the lower tier of self-imposed compliance within the realms of this sector.

Yet, watchdogs have voiced concerns over the number of defaults that could follow a rapid downturn in the economy.

Private equity arrangers behind the leveraged loans defend their niche by claiming that no covenant in the world offers protection against genuine poor credit worthiness, assigning the real security behinds such deals to both the selection criteria and the role of the arranger, which in essence relegates the importance of industry safeguards. The concept goes further, suggesting that weaker covenants actually allow low grade companies to break away from the stringent repayment itineraries associated with bundled debt by providing breathing space for struggling debtors.

US Ratings agency Moody’s expressed concern over rising credit risks as ”less creditworthy firms (were) accessing the institutional loan market”

But in spite of rising interest rates, the leveraged loan market is not immune to slower economic growth; last month’s market sell off sent loan prices tumbling by margins unseen since the US lost its triple A status, in August 2011.

Some arrangers believe this end of turn rout provided a reality check having woken natural caution among lenders, reducing leverage appetite and leading to tightened covenants and higher associated coupons, while others still remain optimistic that spare capacity in the US economy will allow sufficient manoeuvrability over further flexibility in loan arranging.

But with some 70% of the market consisting of so-called “Cov-lite” loans, agreements with lower protection than the usual bindings, regulators are particularly jittery as these loans ultimately have their risk transformed into Collaterised Loan Obligations CLO’s, packages which are then sold on to global investors including insurance companies, pension funds and asset managers. That is, those which are not still sitting on the balance sheets of investment banks.

But with a growing demand for high yield bond issuance which is outstripping supply, coupled with private equity stakes in the corporate world on the rise, borrowers still have a large say in a market that currently outstrips the subprime mortgage arena just prior to the onset of the last global financial crisis.

One of ex Federal Reserve Chair Janet Yellen’s final remarks on the issue was a concern about regulation being unable to reach the non bank sector which is the ultimate destination of these syndicated loans when regulated banks are forced to offload them from their balance sheets.

Clearly, one to watch out for in the coming year.

About the Author

Chandra Roy
Educated at the LSE, Chandra joined Lehman Brothers where he initially traded commodity options, specialising in risk management through OTC & listed derivatives. His career spans over 25 years in international financial markets having held positions in fixed income & money markets, in both London & Madrid. He worked almost 18 years at Grupo CIMD, where he set up and managed the Emerging Markets & Credit division. He currently lectures in International Financial Markets at the Instituto de Estudios Bursátiles, Madrid.