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IMF "Sounds the Alarm" on Leveraged Loans as Credit Quality Deteriorates

Date: Nov 19, 2018 @ 09:00 AM
Filed Under: Economic Commentary

With interest rates extremely low for years and with ample money flowing though the financial system, yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun, acording to an analysis by the International Monetary Fund published last week.

According to analysts Tobias Adrian, Fabio Natalucci, and Thomas Piontek, leveraged loan issuance has reached an annual rate of $745 billion so far this year.

"More than half of this year’s total involves money borrowed to fund mergers and acquisitions and leveraged buyouts (LBOs), pay dividends, and buy back shares from investor—in other words, for financial risk-taking rather than plain-vanilla productive investment. Most borrowers are technology, energy, telecommunications, and health care firms," the write. "At this late stage of the credit cycle, with signs reminiscent of past episodes of excess, it’s vital to ask: How vulnerable is the leveraged-loan market to a sudden shift in investor risk appetite?  If this market froze, what would be the economic impact? In a worst-cast scenario, could a breakdown threaten financial stability?"

According to the authors, it is not only the sheer volume of debt that is causing concern.
 
"Underwriting standards and credit quality have deteriorated," they note. "In the United States, the most highly indebted speculative grade firms now account for a larger share of new issuance than before the crisis. New deals also include fewer investor protections, known as covenants, and lower loss-absorption capacity. This year, so-called covenant-lite loans account for up 80 percent of new loans arranged for nonbank lenders (so-called institutional investors), up from about 30 percent in 2007. Not only the number, but also the quality of covenants has deteriorated."
 
To read the analysis in its entirety, click here 

 

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