The lack of transparency around non-bank investors in leveraged loans and collateralised loan obligations is a key risk for the financial sector, according to a new report from Fitch Ratings examining leveraged lending exposures.
The report – entitled Leveraged loans & CLOs in financial institutions – update – says that around 25 percent of leveraged loan and CLO exposures are in the hands of investors which cannot be identified by the Financial Stability Board, the international monitor of the global financial system.
This means that “spill over effects are uncertain” and “the behaviour of these investors in a stress scenario may propagate risks through the financial system”, according to the report.
“Risks to financial stability from the growth of leveraged loans and collateralised loan obligations are more likely to arise from the non-bank sector, particularly in opaque areas where there is limited information on direct holdings,” said Cynthia Chan, group credit officer – global financial institutions at Fitch Ratings.
The FSB says banks are the largest holders of leveraged loans and ‘AAAsf’ rated CLO notes and held 50 percent of leveraged loan exposures, including CLOs, at the end of 2018. The ratio of exposure to common equity tier 1 across global systemically important banks is 60 percent, which Fitch views as “significant” but “not uncommon or particularly high”.
After banks and CLOs, the largest known holders of leveraged loans are investment funds and the largest known holders of CLOs are insurers. These holdings have increased over time but are still a relatively small share of global fund assets under management.
The report says liquidity risks are most acute for open-ended funds, which offer daily liquidity while investing in large amounts of leveraged loans and CLOs that are not particularly liquid. While the US’s National Association of Insurance Commissioners concludes that the CLO asset class is not a risk to the industry as a whole as holdings are relatively small and mostly rated ‘Asf’ or above, Fitch contends that US insurers could still be vulnerable to losses from lower-rated tranches in a stress scenario.
“Financial stability risk could rise from fire sales and broader market unrest if open-end funds with concentrated leveraged loans holdings face heavy redemptions,” said Chan.
The report concludes that the partial shift in the leveraged loan and CLO markets to non-bank investors may have “introduced new risks, increased interconnectedness across the financial system and created a mechanism to amplify shocks in a downturn”.