Should we be afraid of “leveraged loans” in the United States?

Although there is no unanimously accepted definition, the leveraged loans are commonly defined as loans made by a financial institution to a company with high indebtedness. The US Federal Reserve (Fed) and the European Central Bank (ECB) qualify as a leveraged loan any loan granted to a company whose outstanding debt represents more than 4 times annual profits.

In a context where the debt of non-financial corporations in the United States exceeded the peak of 2008 to reach more than 46% of GDP, its component of leveraged loans also reached record outstandings of $1,800 billion at the end of 2018 (i.e. 3/4 of global outstandings).

This outstanding is broken down between leveraged loans institutional (see graph 1) which represent approximately 1,200 billion dollars (up 20% in 2018) and the leveraged loans non-institutional ($600 billion). While the former are generally used in large syndicated public operations and held by the non-banking sector, the latter are more likely to be held by the banking sector. It should be noted that in Europe outstanding leveraged loans institutional assets are much smaller than in the United States, slightly above $200 billion at the end of 2018.

[Graphique 1 : Encours des prêts à effet de levier institutionnels aux Etats-Unis (courbe rouge) et en Europe (courbe bleue), en milliards de dollars US. Crédit : Banque de France]

A combination of favorable factors

First of all, the environment of persistently low interest rates has pushed investors towards yield-seeking strategies, to which leveraged loans respond favorably because of their higher yield. Unlike the high yield bond market (high yield bonds) which grew to a lesser extent, the market for leveraged loans was supported by the financing needs of companies that sometimes find it difficult to issue bond debt on the markets. The leveraged loans have also benefited from the monetary tightening in the United States since the end of 2015, thanks to their variable interest rate. Furthermore, in the event of default by the borrowing company, the providers of leveraged loans will be reimbursed in priority during the liquidation compared to other investors such as bondholders of this same company.

Demand was also sustained by the dynamism of issues of securitization products backed by these loans (collateralized loan obligations, CLOs), which today hold almost a third of the leveraged loans in the USA.

Given its attractiveness to investors, the market for leveraged loans currently benefits from a balance of power in favor of borrowers. Thus, the reduction or even the disappearance of certain contractual clauses aimed at protecting investors (known as covenants) constitutes the new standard for issuing leveraged loans: this would have concerned more than 80% of the issues of leveraged loans institutions in the United States in 2018.

A vulnerable market?

First, the credit quality of leveraged loansgenerally already in the speculative category, has deteriorated in the United States since the financial crisis (see graph 2). Thus, the share of leveraged loans “highly speculative” institutional bonds (rated B+, B and B-) rose from 30% in 2007 to 54% in 2018.

US Leveraged Loans Rating

[Graphique 2 : la notation des prêts à effet de levier institutionnels aux Etats-Unis. Crédit : Banque de France]

Companies that have contracted leveraged loansby definition highly indebted, are vulnerable to an increase in the cost of debt and a scarcity of financing, particularly in the event of macroeconomic or financial shocks which would increase their risk of default.

Furthermore, the market for leveraged loans is characterized by the importance of non-bank investors (CLOs, investment funds, pension funds, insurershedge funds). Unlike banks which, at the instigation of regulators, have greatly reduced their level of risk since the financial crisis, non-bank investors have taken advantage of a less restrictive regulatory framework to increase their share of this market.

Added to this is the reduction in subordinated debt associated with these loans – i.e. the debt capable of absorbing losses before the senior loans – thus reducing the expected recovery rates and therefore the level of protection of investors.

Finally, a non-negligible part of these loans was not used to finance productive investment, which could have improved the profitability of companies, but rather to finance mergers and acquisitions, buy back shares or pay dividends (Adrian et al., 2018).

Subprimes vs. leveraged loans : comparison is not right

The concerns related to leveraged loans are fueled in particular by apparent similarities with real estate loans subprime, that triggered the 2008 crisis:

– deteriorated solvency of debtors, households or companies,

– strength of the securitization of these speculative loans,

– similar outstanding levels: 1,200 billion dollars leveraged loans institutional debt in 2018 (i.e. around 12% of the debt corporate American) against 1,100 billion dollars of credits subprime end of 2006 (i.e. approximately 13% of mortgage loans).

However, a number of differences persist:

– banks now appear to be less directly exposed to leveraged loans than they were at subprime in 2007-2008,

– the collateral is not residential real estate: the leveraged loans would thus benefit from greater sectoral diversity. Nevertheless, if investors were to apprehend the leveraged loans as an asset class in its own right, then the benefit of sector diversity would be lost,

– finally, securitization appears to be less important today: a third of leveraged loans would be securitized against 80% of the loans subprime in 2007. The liquidity risk is also limited thanks to the maturity of the liabilities generally greater than the average maturity of the assets.

Although the comparison with the subprime appears questionable, the market for leveraged loans nevertheless presents a number of risks for financial stability. The presence as investors of Exchange Traded Funds and Mutual Funds offers unprecedented, albeit minority, access for individuals to leveraged loans in the USA. Moreover, these structures present a liquidity asymmetry between their assets and their liabilities. Indeed, investors can resell their units quickly while the underlying assets (the leveraged loans) have much longer transaction times. A general deterioration in the quality of loans, in the context of macroeconomic or financial shocks, could encourage investors to sell their leveraged loanspushing down prices in the secondary market.

Given numerous vulnerabilities, the market for leveraged loans in the United States could play an amplifying role during macroeconomic or financial shocks affecting the United States. After the Bank for International Settlements and the International Monetary Fund, the Fed also warned on this subject, while considering that the risk incurred by the leveraged loans however, was not systemic.