Be very afraid, because the seeds of the next global financial crisis are to be found in the leveraged loan market. That, at least, would be the reasonable conclusion to draw from comments made by Mark Carney, governor of the Bank of England, when he said in January that, while the analogy “isn’t perfect”, leveraged loan underwriting bore a real resemblance to that which supported the subprime home loan bubble in the US before that market’s spectacular collapse.
Those of a nervous disposition will not have had their anxiety alleviated this month by news that the Financial Stability Board, the global regulator, was poised to launch an investigation into parts of the leveraged loan market over fears of a risk to financial stability.
As a firm which participates actively in the leveraged loan market through CLOs – the largest buyers of leveraged loans – Swiss private markets firm Partners Group decided to examine whether the mounting concern was justified through a white paper published this week: “The current state of the leveraged loan market: are there echoes of the 2008 subprime market?” Cutting straight to the conclusion (spoiler alert): stop worrying quite so much.
Now, this is not a fashionable view, as the authors of the white paper readily acknowledge. In December the leveraged loan markets saw a huge outflow of capital – mainly in the US but, to a lesser extent, in Europe as well. Some took this as a sign that the much-touted ending of the credit cycle was finally manifesting itself.
According to the white paper authors, this was far from the case. CLOs, the largest leveraged loan investor base, are traditionally not very active in December; while a lot of short-term, liquid mutual fund and high-net-worth money was temporarily withdrawn that month only to be re-invested in January. Indeed, the new year saw plenty of institutional money piling into the market as falling prices presented a secondary market buying opportunity – inspiring a “V” shaped recovery. In the US, 75 percent of the market’s fall in December was recovered the following month.
But while fears of Armageddon have subsided, are there not still justifiable concerns about a market that has grown too quickly for its own good? Does its sheer size not pose systemic risk? On the face of it, the leveraged loan market has grown very rapidly – roughly doubling in size in the US between 2008 and 2018. However, this growth is not out of kilter with that seen in the US corporate bond and high-yield markets – which have attracted far less media attention.
A further concern is over the deterioration of credit quality, with public ratings in the US leveraged loan market showing a migration to lower-rated issuers. But again, this is not out of step with other comparable markets and may at least in part be down to a tougher stance from the rating agencies, stung by the fierce criticism they received for the missteps that contributed to the global financial crisis.
The bad news is not all fake news, the authors are keen to add. They acknowledge that aggressive documentation features – EBITDA addbacks, incremental loan facilities, loose covenants and the like – are all of great concern. Thorough due diligence and playing the market intelligently has never been more important.
But these specific issues should not lead seamlessly to the conclusion that here is a market ripe for implosion. Many will conclude, given the political and regulatory scrutiny, that there is no smoke without fire. While that may be the case, Partners Group’s analysis should be welcomed for bringing intellectual and statistical rigour to the debate, while simultaneously challenging easy assumptions.
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