Could leveraged loans trigger a debt crisis?

By: Tim Bennett
10.10.2018

Leveraged loans are a new type of debt that has taken the corporate world by storm recently. Tim Bennett looks at how they work and the key risks.

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Could leveraged loans trigger a debt crisis?

Leveraged loans are hugely popular way for companies to raise finance privately. So how do they work and what are the risks?

The problem

Whilst leveraged loans are seen as the preserve of private markets these days, the Bank for International Settlements (BIS) is nonetheless worried. That’s because of the potential ripple effect should leveraged loans start to go bad in big numbers;
So what are these new, potentially disruptive instruments?

Leveraged loans – the new junk bonds?

Whilst leveraged loans are compared frequently to their forerunners, junk bonds, they are infact different. In short, junk bonds are tradeable IOUs that offer high yields to investors in return for no security.
Leveraged loans, on the other hand, are direct loans to companies that are already substantially in debt (“leveraged”). Between them, these two types of risky lending make up roughly half each of a $2.65bn market.
The latter have become popular in recent years as they offer a few key advantages (in the eyes of lenders and borrowers) over conventional bonds;
So, where’s the risk? One of the issues that most worries regulators is the rise, within the leveraged loans market, of the “cov-lite” agreement.

A quick guide to “cov-lite”

A conventional loan between a lender and a borrower will commit the borrower to meet certain criteria laid down in covenants within the agreement. These may require adherence to all sorts of conditions regarding financial performance and even the retention of key staff.
However, in order to win lending business, new lenders have been waiving these clauses and creating covenant-light agreements. Naturally, borrowers are more than happy to comply with these less onerous deal terms.
But this is not the only innovation that is causing some concern.

Collateralised loan obligations (“CLOs”)

In order to offer out as much of this debt to as wide a pool of lenders as possible, firms have started to bundle up leveraged loans into packages and then sell an interest in it (a “tranche”) to willing lenders. Because these CLOs are built on high yield loans, they also carry an attractive rate of interest.

The potential danger

This fast growing market for the loans themselves and related instruments, such as CLOs, works as long as interest rates stay relatively low and heavily indebted borrowers are able to fund their obligations to lenders. The worry is that should interest rates rise fairly fast (as they appear to now be doing in the US) high risk borrowers will come under pressure and may start defaulting on their outstanding loans. And whilst many leveraged loans carry some sort of security, liquidating it and realising its value could prove difficult should there be a “rush for the exit” as multiple lenders all try to enforce their rights. That, in turn, could cause a ripple effect through the CLO market and put pressure on guarantors, such as Clearing Houses and even mainstream banks.
At this point (late 2018) there are no signs of widespread distress. However, whether this remains the case will depend heavily on the path of interest rates and, say regulators, how successfully covenant-light debt risk is being managed. It’s certainly a space that investors should keep a watchful eye on.