Goldman Expects Moderate to Low Risks on Leveraged Loans, CLOs

(Bloomberg) -- Wall Street may be looking to the credit markets for signs of deterioration, but it might not be worth hitting the panic button just yet.

Risks to financial stability from leveraged-loan and collateralized-loan-obligations markets pose just a moderate risk to financial stability, and the default risk on CLO AAA tranches is likely to stay relatively low, according to Goldman Sachs Group Inc. The risk of runs on the short-term liabilities of banks driven by losses on leveraged loans or CLOs is also small.

“While the rapid growth, easing in lending conditions and relatively low spreads signal somewhat frothy conditions in the leveraged loan and CLO markets, we still view the risks to financial stability as moderate,” economist Daan Struyven and credit strategist Amanda Lynam wrote in a note Friday. “The default risk on CLO AAA tranches is likely to remain relatively low.”

READ: Fed Monitoring Funds’ Leveraged Loan Investments, Quarles Says
READ: Fed’s Warning on Leveraged Loans Seconded by U.S. Bank Regulator

Leveraged loans have grown by 15 percent on average over the last 20 years, the firm said, largely due to a shift of the mix within leveraged finance driven by funding moving away from high-yield bonds. Borrowers have found the flexible repayment terms attractive, while many investors have found the floating-rate structures appealing in the last couple of years, the economists said.

Goldman Expects Moderate to Low Risks on Leveraged Loans, CLOs

Default risk on leveraged loans will remain moderate in the near-term due to strong corporate earnings fundamentals, relatively low near-term recession risk and debt-servicing capacity that remains strong, the report said. Default risk on CLO AAA tranches should stay fairly low, looking at prior history and due to the degree of credit enhancement, it said.

Though spreads have tightened in the past couple of months, the S&P LSTA leveraged-loan spread of 410 basis points is at just its 28th percentile in data back to 1997, the report said, adding that CLO spreads are significantly wider than in early 2007 but also remain relatively low. The benchmark S&P/LSTA Leveraged Loan Index fell 0.08 percentage points on Friday to 95.44, the lowest since Oct. 7, 2016.

The risk of runs on the short-term liabilities of banks driven by losses on leveraged loans or CLOs is low, the economists wrote. Banks own less than 5 percent of outstanding leveraged loans, an exposure of 2.5 percent of total bank equity, and hold relatively little of the riskier junior CLO tranches, they said.

©2018 Bloomberg L.P.