The IMF is latest to warn about $1.3 trillion in risky ‘leveraged loans’

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• The IMF has joined leading policy makers, major central
  banks, and global investors in raising the alarm over the
  buildup of corporate debt.
• It said default rates are rising, while growth in
  “leveraged loans” with less protection for investors are now
  more than double the levels pre-financial crisis.
• Excessive corporate leverage makes the global economy
  more vulnerable to negative shocks as central banks continue to
  tighten liquidity.

The buildup of risky debt in corporate credit markets has caught
the attention of the Bank
of England and
the Federal
Reserve.

It’s also been highlighted by
global fund managers in the latest industry
survey by Bank of America Merrill Lynch.

Now the International Monetary Fund (IMF)
has added
to the clamor, warning that an unwinding of the market in
so-called “leveraged loans” — credit from non-bank lenders to
risky or highly-indebted companies — could have untold
consequences for the global economy.

“With interest rates extremely low for years and with ample money
flowing though the financial system, yield-hungry investors are
tolerating ever-higher levels of risk and betting on financial
instruments that, in less speculative times, they might sensibly
shun,” the IMF said.

“It is not only the sheer volume of debt that is causing concern.
Underwriting standards and credit quality have deteriorated.”

As evidence, they cited research from credit-ratings agency
Moody’s showing the buildup of “covenant-lite” loan terms.

Lighter covenants mean less protections for creditors in the
event of a company not being able to make its repayments.

This chart shows the buildup of covenant-lite loans in US debt
markets.

This IMF chart shows
covenant quality
International
Monetary Fund

The IMF also warned that lenders could be issuing loans on
dubious information from borrowers, noting that “weaker covenants
have reportedly allowed borrowers to inflate projections of
earnings. They have also allowed them to borrow more after the
closing of the deal.”

While default rates have remained low, the recovery of investor
capital from the companies that do fail has fallen sharply. “With
rising leverage, weakening investor protections, and eroding debt
cushions, average recovery rates for defaulted loans have fallen
to 69% from the pre-crisis average of 82%,” the IMF said.

The vast majority of risky leveraged loans have been issued by
large institutional investors on the hunt for yield, which
presents a separate risk.

Institutions now hold about
$1.3 trillion of leveraged loans in the US market, more than
double the level held prior to the 2008 financial crisis.

And the vehicle of choice among sophisticated investors to buy
all this risky debt is a collateralised loan obligations (CLOs) —
a process where loans are packaged up and on-sold to other
investors.

“CLOs buy more than half of overall leveraged loan issuance in
the United States,” the IMF said.

“Institutional ownership makes it harder for banking regulators
to address potential risk to the financial system if things go
wrong.”

As Morgan Stanley highlighted in research this week, corporate
bond risk is
more of a medium-term threat while global
financial conditions remain relatively accommodative.

However, it makes markets more vulnerable to negative shocks if
liquidity continues to tighten.

You can read more at the IMF here.