(Bloomberg) -- A dark corner of the financial market springs to life. Money piles in. Prices surge. Small investors clamor for a piece of the action. In the frenzy, risks are pushed aside. We've seen this movie before, and the later scenes usually aren’t pretty. With so-called leveraged loans — high-interest, floating-rate borrowing by companies with shakier credit — the ending still isn’t clear. Their growth has been explosive, providing more than $1.3 trillion in loans used by U.S. companies and private equity firms to do things like fund buyouts, pay shareholder dividends and refinance borrowings. But not all bubbles end with a bust — sometimes the air just leaks out of them. If there’s a happy ending, it might be the work of regulators who tried to crack down as debt piled up, or it might be because the money simply moved elsewhere as interest rates rose on safer alternatives.
The market for new U.S. leveraged loans had almost doubled between 2012 and 2017, when a record $1.1 trillion were issued. But loan sales fell to $814 billion in 2018, as global turbulence knocked the wind out of the assets starting in late October. Sales for December hit their lowest since 2011, prices plunged and investors pulled money from funds that invest in loans at a record pace. But, in a sign of how volatile leveraged loans can be, the market quickly began to rebound in January as buyers were lured back in by newly cheap valuations. The surge in 2017 had been fueled in large part by the U.S. Federal Reserve’s planned campaign of rate hikes, which made the floating-rate loans more attractive to some investors as a hedge against possible losses on fixed-rate borrowing. Leveraged loans also still offered more yield than the pervasively low rates on higher-rated investments. Adding fuel to the fire was a loosening of the limits that U.S. regulators had set on leveraged loans in 2013. Banks grew bolder in piling debt onto firms, often under easier terms, in a bonanza that led to expressions of unease from the Bank of England and the International Monetary Fund as well as the Fed. Leveraged loans are also on the rise outside the U.S., though the market is smaller and more of the debt is retained by banks.
In the credit market, bonds have traditionally gotten the bulk of attention. But investors sometimes prefer loans to bonds because they offer payments tied to floating benchmark rates, so loan holders benefit when rates rise. And if a borrower defaults, high-yield loans are likely to recover more money than their high-yield bond counterparts, because they typically rank ahead of junk bonds in bankruptcy proceedings. Loans usually have another layer of protections known as covenants that allow lenders to do things like force the asset sales if earnings deteriorate. There is no direct oversight of the loan market in the U.S., a situation that stems from securities laws from the 1930s, when loans were mainly private transactions between a single bank and a borrower. Nowadays, banks arranging loans sell them to pension managers, mutual funds, hedge funds and ETFs. The biggest buyers are firms that repackage the loans into collateralized loan obligations, securities that have varying risk and return. Similar securities that pooled subprime mortgages were blamed for triggering the 2008 financial crisis when the U.S. housing bubble burst. The leveraged loan craze deepened amid the wreckage of that crisis, as years of record-low interest rates fueled demand for investments offering a higher return. When the 2013 limits set by regulators led big banks to pull back, other kinds of lenders, known as shadow banks, stepped in – fanning concern that risks had simply been shunted out of regulatory view. During the boom, borrowers were able to sell debt with weaker covenants as yield-hungry investors scrambled to get in on leveraged loans.
As the U.S. Federal Reserve raises interest rates, leveraged loans may provide an important test of whether the post-crisis system can manage changing risks. Money managers who buy leveraged loans say they know how to tell the good deals from the bad ones; other investors say they’re adequately hedged against any turmoil driven by higher interest rates. Supporters say the leveraged-loan rebound early this year after an exodus that included four of the largest weekly outflows on record showed how sturdy the market is. To critics, that whipsawing has raised concerns about how healthy a market that fluctuates so wildly can be — and how it will fare when a downturn takes hold.
The Reference Shelf
- The International Monetary Fund sounded an alarm on leveraged lending in November 2018.
- Bank of England Governor Mark Carney’s speech 10 years after the financial crisis also warned of increasing leverage.
- Association for Financial Markets in Europe report on leveraged finance.
- Federal Reserve Bank of New York paper on lessons from leveraged lending guidance.
- The Fed’s March 2013 guidance on leveraged lending.
- Leveraged loans are only bad when investors aren’t properly compensated for the risks, writes Bloomberg Opinion columnist Brian Chappatta.
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