Bank of England Warns Junk-Debt Froth Could Amplify Any Downturn

(Bloomberg) -- Increased risk taking in global financial markets, particularly in leveraged debt, could worsen future downturns, according to U.K. monetary authorities.

As borrowing in global junk-rated debt markets continues to climb, valuations are vulnerable to changes in growth prospects and the path of interest rates, officials wrote in the Bank of England’s Financial Stability Report.

“Elevated asset valuations and compressed risk premia imply a vulnerability to a sharp correction in asset prices,” according to the report. “Sharp decreases in asset prices can amplify economic shocks” and directly affect the financial system.

The share of high-yield corporate bonds is currently at its highest level in the past decade, and there’s evidence of loosening underwriting standards, especially in leveraged loan markets, according to the report.

Borrowers are more indebted and a record 72% of new lending in these markets have no maintenance covenants, compared to around 65% in the first quarter of 2020 and around 14% in 2007, the report noted.

Officials are sounding the alarm after companies around the globe sold an unprecedented amount of junk bonds in the first half of the year as borrowing costs fell to record lows and investors clamored for higher-yielding assets.

Read More: Leveraged Loan Investor Defense ‘Destroyed’ Amid Rampant Demand

The U.S. and Europe leveraged loan market has also been bustling with activity, with volumes soaring to a 14-year high in Europe for example, according to data compiled by Bloomberg.

The market for collateralized loan obligations (CLOs), the biggest buyers of these loans, has swelled past $1 trillion, according to research by JPMorgan Chase & Co.

CLO issuance is over 135% to 150% of the levels seen over the past five years, while refinancing and setting activity is at record high levels, the BOE report said.

When it comes to the U.K. specifically, officials judged that corporate indebtedness in the country has increased only modestly in the aggregate. Still, they noted the change has been substantial in some sectors and among small and medium-sized firms.

They warned that companies with weaker balance sheets, particularly in sectors affected by pandemic-related restrictions, may be vulnerable to increases in financing costs.

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