Although a turn in the credit cycle might excite investors in distressed debt, it poses a major concern for the world’s financial regulators.
As the global economy starts to diverge from a long period of benign market activity and sees a return to volatility, there is growing fear that the next financial crisis could already be bubbling away somewhere in the system.
One area that has caught the eye is the leveraged loan market, and a succession of major regulators – including the European Central Bank, the US Federal Reserve and the International Monetary Fund – have all raised issues around it. Most recently, the Financial Stability Board chairman Randal Quarles said his organisation was so concerned that it will begin a review of the market during 2019.
Quarles’ proposed review follows hot on the heels of an FSB report, published in February, on the role of non-bank financial institutions, including private debt funds. The report estimated that institutional leveraged loans alone were worth $1.4 trillion, more than half of the estimated $2.2 trillion-$2.4 trillion of outstanding leveraged loans.
The FSB said it was particularly concerned about the high-yield debt market, which has seen a significant increase in multiples in recent years to above pre-crisis levels. The board also highlighted a similar trend in lending to corporates with credit ratings of B or lower (which it said was often where private equity investors were to be found), with average gross debt-to-EBITDA multiples exceeding 5x globally and even 6x in some parts of the world.
The FSB summed up its concerns thus: highly leveraged corporates “may be more vulnerable to economic downturns, to liquidity stress and potential defaults. Furthermore, while credit spreads increased at the end of 2018 in the major high-yield debt markets, many investors that invested over the past years at post-crisis low credit spreads may have under-priced the weakening in covenant quality, as well as the risks presented by an increase in corporate indebtedness”.
In addition to mispriced risk, lenders are grappling with a deterioration in terms that has been taking place for more than a year (see our cover story on p. 14). Data from Debt Explained found the proportion of covenant-lite deals in Europe had increased from 17 percent in Q4 2017 to 64 percent in Q3 2018. These trends are likely to have been factored into the FSB’s decision to review the leveraged loan market.
Ioana Barza, director of analysis at financial markets data provider Refinitiv, says that outright leverage levels are not yet above the peak seen shortly before the financial crisis. However, she adds that new factors could change the way that problems in the leveraged loan market develop in a future downturn.
“One thing we see today that we didn’t see back in 2007 is that the level of senior debt is very high and we’ve had much less junior debt,” she explains. “This means there is much less of a cushion between the equity and senior debt, which could increase loss rates.”
Barza says that as private credit funds have become bigger players in leveraged finance, the amount of deals financed by unitranche or stretched senior have increased. Senior debt volume is also growing due to the increasingly high multiples that private equity sponsors are paying for companies, which means they are driven to borrow more. A recent survey of asset managers by Refinitiv found this to be a concern in the industry too. A further alarming development is that investors expect loss rates to be higher. Refinitiv found that 58 percent expect recovery rates in the next downturn to be lower than the historical average.
The role of covenant-lite loans could be significant as companies will be in a worse financial position when they default than they would have been in 2008-09. Barza says the combination of weak covenants and the lack of a junior credit cushion could lead to lower recovery rates, even if the next downturn is not as severe as the last.
Clearly there is cause for concern about leveraged loans, and it would be remiss of the FSB not to investigate. However, the case for additional regulation of the alternative credit sector is less clear. Though some funds may be taking excessive risks, they are doing so with money provided by professional investors, not retail depositors, which makes it difficult to justify a regulatory clampdown.