Everyone’s talking about the leveraged loan market lately and how it threatens to cause the next financial crisis. The only ones not worried about it are investors, according to Moody’s Investors Service. “Investor demand for leveraged loans has soared in 2018, fueled by an appetite for floating-rate instruments, accommodative markets and a low default rate forecast,” Enam Hoque, vice president and senior covenant officer at Moody’s, said in a note to clients. “And borrowers continue to capitalize on this demand by negotiating flexible covenant structures, with weakness not limited to ‘cov-lite’ loans, but apparent across all risk categories.”
In the last six years, the outstanding value of leveraged loans in the US has doubled to $1.1 trillion, according to S&P Global Market Intelligence. This is a level that concerns regulators and ex-regulators alike. The Fed discussed leveraged loans at its FOMC meeting in September and several agencies and international organizations, including the Bank of England, the Bank for International Settlements and the IMF, have all issued warnings about the ballooning leveraged-loan market. Ex-Fed Chair Janet Yellen also said she was concerned about the market in an interview with the FT.
Moody’s says its Loan Covenant Quality Indicator (LCQI) weakened further in the latest quarter and is close to its all-time record-worst level. The LCQI deteriorated by four basis points to 4.09 (weak) in the second quarter of 2018, versus 4.05 in the first quarter of 2018. What may be worse, Moody’s says, is that it’s actually not just covenant-light loans. “Weakness not limited to ‘cov-lite,’ ” Moody’s writes in its note. This is because weakened covenant protections have been found “across all risk categories.”
“While protections around financial maintenance covenants have deteriorated with the rise of covenant-lite loans, protections around restricted payments, debt incurrence, and investments are also near record-weak levels,” according to the Moody’s note. “Borrowers continue to capitalize on investor demand for leveraged loans by negotiating for flexible covenant structures. Investor demand remains high, fueled by an appetite for floating-rate instruments, accommodative markets, and a low default rate forecast.”
A lot of red flags but they only matter if the economy tanks in the next few months. Otherwise, leveraged companies will be able to service the debt without an issue and with a longer period to repay the debt. iT