Low interest rates and the resulting search for yield have propelled corporate debt to a record high. In aggregate we believe this is manageable, as low interest rates and record profits allow corporations to service their debt easily.
Despite healthy corporate balance sheets, the leveraged loan market has recently been drawing headlines and fixed-income investors are interested in knowing more. Leveraged loans are floating-rate, secured, callable debt instruments issued by non-investment grade firms to fund acquisitions, dividends and operating needs - and interest payments naturally represent a greater percentage of their earnings. The Economist reports roughly 10% of America's non-financial debt is issued by firms whose debt service accounts for half of their pre-tax earnings. However, market watchers have noticed that these more heavily indebted corporations (defined as greater than 4x EBITDA) are adding debt more quickly than their lower-geared counterparts; while aggregate non-financial debt doubled since 2012, firms with higher debt tripled their borrowing over the same period.
As post-Great Financial Crisis (GFC) regulatory change shaped bank risk-taking and other market dynamics, these firms are increasingly funded in the leveraged loan markets, which now surpasses U.S. high-yield bonds. These loans are typically originated by banks and are purchased by institutional investors looking for credit exposure similar to floating-rate high-yield fixed income instruments. Notably the strong demand for leveraged loans has allowed issuers to reduce covenant protection in the terms, which have converged with those in the high-yield bond market.
The sharp uptick in these covenant-light bonds has prompted concerns from a variety of market stakeholders. Notably, we have seen statements from Federal Reserve policy makers, the BIS, FSOC, IMF and others describing the inherent risks of these securities, making comparisons to prior debt binges. Their concerns seem reasonable: the academic literature strongly suggests that sharp increases in debt can exacerbate possible downturns and that the asset class is less liquid.
Indeed, if earnings quality were to deteriorate or if interest rates increase significantly we would expect default rates to rise and begin impacting debt markets. However, we expect rates will be stable for the near term and our recession outlook is benign. In addition, bank direct exposure to leveraged loans is limited and typical exposure is to the highest quality securities (see our recent blog post on complex credits here). Finally, we believe that relative to the GFC, the current institutional market structure is less levered and with longer-term funding that should allow more orderly markets.
American Banker, Fed warns over leveraged lending as banks chase riskier deals, October 24, 2018
Bank for International Settlements (BIS), The rise of leveraged loans: a risky resurgence?, September 2018
Chen, S., Ganum, et. al, Debt Maturity and the Use of Short-Term Debt, IMF Departmental Papers / Policy Papers, 19(03), 1., 2019
Financial Stability Oversight Counsel, 2018 Annual Report
J.P.Morgan, 2018 Leveraged Loan Annual Review, February 2019
Lee, Lisa, How Leveraged Loans Are (and Aren't) Like Junk Bonds, Bloomberg, September 30, 2018
Reinhart, Carmen M., and Kenneth S. Rogoff. 2008, Is the 2007 US Sub-Prime Financial Crisis So Different? An International Historical Comparison, American Economic Review: Papers and Proceedings 98 (2): 339-44, 2008
The Economist, Should the world worry about America's corporate-debt mountain?, March 14, 2019
The Economist, What are leveraged loans?, January 11, 2019