The leveraged loan market is one corner of the credit markets that is thriving in the face of rising interest rates. But red-hot demand for such loans in the past year is raising red flags for market analysts.
Leveraged loans are made by lending syndicates to non-investment-grade companies. With a floating interest rate typically pegged to the three-month London Interbank Offered Rate, they provide protection against rising interest rates.
The money is often used to finance mergers and leveraged buyouts — off to a strong start this year — but not always, as more borrowers tap extremely strong demand for such loans.
"We often see more demand for loans from investors and borrowers in the latter half of the business cycle," said John Fraser, head of credit management at Investcorp, which has multiple funds managing over $5 billion in the U.S. loan market. It manages another $6 billion in the smaller European market. "With good but not explosive growth in the economy and the Fed raising rates, it's the perfect environment for the loan market."
Retail investors like the idea of floating rates and more security than high-yield bonds. More than $11 billion has flowed into the 64 bank loan mutual funds so far this year, according to data from Morningstar. Total assets in the funds now top $144 billion.
At the end of 2017, there was more than $1.36 trillion in outstanding loans, according to Moody's research, making the loan market now slightly bigger than the high-yield bond market.
While the strong investor demand has helped leveraged loans post a roughly 2 percent return so far this year compared to a flat total return for high-yield bonds, the terms of the loans have deteriorated dramatically in the last several years. Many market analysts expect that investors in loans made today could face major losses if and when the economy turns and borrowers default on the loans.
"We've seen this in the past," said Fraser. "Whenever the market is strong, terms become more borrower-friendly. "Credit risks will grow in the future. In this environment we tend to say no to aggressive terms," he added.
It appears everyone else is saying "yes" to those terms. Leveraged loans, unregulated by the Securities & Exchange Commission, are governed by covenants that stipulate what provisions — if any — borrowers must follow to preserve the interests of lenders. Usually they involve maintaining interest coverage and leverage ratios, as well as preserving the position of lenders in the company's capital structure.
One of the chief selling points of leveraged loans has been their seniority to bond- and stockholders and their call on corporate assets in the event of default. First-lien, however, is not what it used to be and protection for lenders is at an all-time low in the market.
"We have never seen weaker loan covenants," said Derek Gluckman, senior covenant officer for Moody's Investor Services, which provides credit ratings for leveraged loans. That includes prior to the financial crisis. "As demand continues to be strong, the loan terms keep softening."
Moody's now characterizes more than 80 percent of new loans in the market as so-called "covenant lite" loans. They have no financial maintenance restrictions and they give borrowers lots of flexibility to issue more debt, pay out dividends to shareholders and even pull collateral out from under lenders. "Covenant lite is just the tip of the iceberg," said Gluckman. "All the provisions are weaker now across all categories."
In December 2016 J. Crew Group, a clothes retailer owned by private equity firms Texas Pacific Capital Group and Leonard Green & Partners, shifted assets into an unrestricted subsidiary out of the reach of lenders. Despite lawsuits from those lenders, the company prevailed thanks to a weak loan covenant.
Private equity owners, known for their aggressive financial engineering, account for approximately 40 percent of borrowing in the leveraged loan market. When things go south for their companies, the interests of lenders won't be top of mind for them.
So far, few companies have executed J. Crew-like asset transfers, but the flexibility to do it is now baked into more and more loan covenants. "Collateral stripping might not be widespread, but how many more companies will do it in a down-cycle," Gluckman said. "The risk is there."
There are no immediate worries about the market. Moody's is projecting default rates in the high yield sector to drop from 3.9 percent at the end of March to 1.7 percent a year from now — in part because of the increased financial flexibility that weak loan covenants are giving companies. The bigger worry is that when the economy turns and default rates do rise, the recovery rates for lenders could be disappointing.
Historically, investors in leveraged loans have recovered 70 cents to 80 cents on the dollar in defaults. That compares to about 60 percent for senior secured high-yield bonds and a little more than 40 percent for unsecured bonds. Investors might take comfort in the fact that leveraged loans did relatively well through the last downturn after the financial crisis. However, Gluckman suggests the next down-cycle may be tougher on lenders.
For one thing, the cushion protecting lenders' principal is smaller, he said. Prior to the financial crisis, about one-third of the average borrower's debt was below leveraged loans in the financial pecking order. The figure is now about 20 percent. Borrowers also had the Federal Reserve help them out of their hole last time around.
"Default rates reached the mid-to-high teens but came down quickly in part because of quantitative easing," said Gluckman. "There's concern that the next downturn could be longer and more painful."
For certified financial planner Mark Cortazzo, senior partner of Macro Consulting Group, the weak loan covenants and murky financials available on many borrowers are enough to keep him from chasing yields in leveraged loans. "This market is a lot more opaque than the bond market," he said. "There could be ugly stuff happening under the waterline."
Cortazzo said that investors are not respecting risk in the market and thinks that the market could turn rapidly when sentiment sours. "Think how quickly things unwound in 2008," he said. "These things tend to be fine and then you get hit hard and fast."