welcome to the world of variable rate corporate debt!

Corporate debt also has its subprime. A bubble of size equivalent to that of 2008 at the American level… and double at the global level. Watch out for the Berezina…

As we saw yesterday, if you add the bank loans granted by banks to American non-financial companies (in green), to the debt high-yield (junk bondsin yellow) and the debt investment-grade (in blue), you arrive at more than $10,000 billion.

What you need to know about bank loans is that they can be granted on the basis of very “variable” guarantees, we will say to be polite, depending on the head of the client and the banks.

The reality is that the level of guarantee required by American banks is often close to what the latter demanded in the early 2000s from poor individuals wishing to acquire real estate.

Among these loans, the riskiest are the leveraged loans. These leveraged loans are indeed the subject of a characteristic that particularly exposes them to the main risk of our time.

Leveraged loans market : towards a Berezina with the rise in interest rates?

Here is what four agents of the Banque de France wrote in July on this subject:

“Although there is no unanimously accepted definition, 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) call a leveraged loan any loan made to a company whose outstanding debt is more than four times annual earnings. […]

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. »

You read correctly: in addition to the fact that these loans are granted to companies whose financial health is quite questionable, they are variable rate loans!

Needless to say, therefore, that in the event of a restriction in banking regulations or a rise in rates, the companies that have benefited from such loans could find themselves in very serious difficulty, and with them the banks which would find themselves with these deficient loans in their balance sheet.

A market of equivalent size to that of subprime in the United States… and twice that worldwide!

When publishing his Financial Stability Report in May, the American Fed valued this market segment at $1,147 billion for the United States alone, after a 20% increase in 2018.

To put things into perspective, this represents roughly speaking the same area as the market for subprime mortgages in 2006.

But the leveraged loans are not specific to the United States: on January 29, the Bank of England estimated that we should count on the double at the global level ($2,200 billion)…

Leveraged loans : tensions since June

Admittedly, as the Fed indicated in May, “the default rate on leveraged loans has recently fallen slightly to a level near the low end of its historical range”.

However, the index that represents these debt securities (the S&P/LSTA Leveraged Loan Price Index) decoupled from the S&P 500 in June, and has been falling continuously since…

Bloomberg reports this:

“Fifty companies that have at least $40 billion in loans have lost around 10% of their face value in the last three months. An exodus of investors was seen in the leveraged loan market from late summer to early fall as liquidity dried up. This is mainly due to lower Treasury rates and rising fears about the end of the business cycle, with a recession possibly hitting next year. »

October 9: “Debt market ‘quietly collapsing’ as billions in loans suddenly unscrew”

Towards a new financial “carnage”?

And ZeroHedge comments:

“Deteriorating collateral standards in the lending market have allowed companies exposed to a downgrade in their credit rating when the economy slows to get loans.

[…] The market for leveraged loans is therefore comparable to the market for subprime mortgages [NDLR : subprime] ten years ago. This is a major imbalance that will be corrected in the next recession and will amplify the next economic downturn.

[…] Accumulation of excessive debt and high exposure to non-financial corporate loans heightens uncertainty that corporate America, as indebted as it is, could face an epic implosion if the next recession starts in 2020.”

This observation is not a concern confined to a financial blog permabear as ZeroHedge, since the Fed itself made the following observation as early as May:

“Moody’s Loan Covenant Quality Indicator suggests that overall loan covenant stringency is approaching its lowest level since the index’s inception in 2012, and that the fraction of cov-lite leveraged loans (leveraged loans without a financial guarantee maintenance commitment) has increased considerably since the crisis. »

On June 5, Bank of America (BofA) feared nothing less than “carnage” in this sector.

Here is what Brian Moynihan, the bank’s CEO, said at the time:

“We don’t see anything yet because the economy is good, companies are making money. The problem is one of leveraged funding. »

Quite an amusing statement when you consider that BofA has long been the market leader in leveraged loans…

In case of “carnage” on the debt corporate insurance companies and American pension funds, which have gone to chase returns on the markets by taking more risks, would be the hardest hit.

As for exposure to only leveraged loanshere is what the Fed said in its May report:

“Leverage leveraged loans are primarily held through mutual funds and collateralized loan obligations (CLO). CLOs are securitized products which are in turn held by various investors [NDLR : comme pouvaient l’être les collateralized debt obligations, actifs les plus touchés lors la crise des subprime]. Based on the limited data currently available, investments in CLOs are roughly evenly split between domestic and foreign banks, insurance companies, mutual funds and other investors. »

In short, almost all categories of investors are concerned.

We will soon discuss the conclusion of this series on debt corporate !

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