In the last twelve months, I have written almost thirty articles about leveraged loans and collateralized loan obligations (CLOs), because these instruments are all too often illiquid and opaque. Moreover, measuring their market, credit, and market liquidity risks is difficult, especially in an economic or market downturn. The Bank for International Settlements, in its Quarterly Review released today, estimates that the global leveraged loan market is about $1.4 trillion, a rise of 100% since 2007. The vast majority of those leveraged loans, $1.2 trillion, are in U.S. dollars, with the remainder mostly denominated in Euros. However, according to a research piece by The Bank of England (BOE), the leveraged loan market globally is more than $2.2 trillion. According to BOE researchers, the commonly cited figure for the size of the leveraged loan market “is the value of loans in indices that are used to track performance of the leveraged loan market.” The researchers believe that “this underplays the true size of market, “ because “it only captures loans that are distributed to non-bank, institutional investors. And, within that, it mainly captures larger, more liquid loans.” When they accounted “for smaller, less liquid loans, as well as lending facilities that are held by banks, the size of the market is more like US$2.2 trillion. Around US$1.8 trillion of this is typically held by non-bank institutions.” It is important to note that larger more liquid leverage loan amount is comparable to the amount of U.S. subprime mortgages before the 2008 financial crisis.
Measuring the size of the leveraged loan market is not straightforward, because there is no consistent definition of what a leveraged loan is. Typically, leveraged loans are underwritten to companies which have levels of indebtedness 5 times or higher, than their Earnings Before Interest Tax and Depreciation (EBITDA). Many of these nonfinancial companies are rated below investment grade (junk bonds) or are unrated, and their level of leverage has been rising.
Of great concern should be that the definition of EBITDA, which is used as an important metric to determine if a company is profitable and what its credit quality is, has been increasingly distorted significantly in loan agreements. According to an early September report by lead writer, Enam Hoque, who is a Senior Covenant Officer at Moody’s Investors Services, “One third of the loans we reviewed in 209 provide for virtually uncapped EBITDA ‘add-backs” for restructuring charges, cost savings and other syneries before they have been achieved.” What this means is that “ by boosting EBITDA, these add-backs can improve leverage or interest rate coverage ratios.” This provides companies a lot more flexibility to take on more debt, pay dividends “or take other actions that could increase credit risk-without breaching their covenants.” In an S&P Global Ratings study of add-backs, S&P analysts found that “companies and deal arrangers have become increasingly creative in presenting what qualifies as an add-back, resulting in an increase in both the number and types of adjustments. In some of these cases, S&P Global Ratings views the act–expanding the definition of management-adjusted EBITDA to inflate “marketing EBITDA” (EBITDA plus add-backs)–as an artificial deflation of leverage.”
After underwriting leveraged loans, bank and nonbank lenders, usually sell the loans to retail funds, insurance companies, pension funds and Exchange Traded Funds (ETFs). Additionally, banks sell leveraged loans to special purpose vehicles, and usually together with nonbank financial institution, bankers will structure the loans into an asset backed security called, a collateralized loan obligation (CLO). According to today’s BIS quarterly review, “As of June 2019, over 50% of [the $1.4 trillion] outstanding leveraged loans in US dollars and about 60% of in euros had been securitized through CLOs.” Leveraged loans that are not in CLOs reside on balance sheets of banks, as well as on the balance sheets of insurance companies, pension funds, retail funds, and other types of financial institutions. Anyone who holds a leverage loan can be adversely impacted if the leveraged loan borrower defaults or deteriorates in credit quality.
According to LCD News of S&P Global, a new record 80% of outstanding leveraged loans in the U.S. are covenant-lite, about $940 billion; LCD estimates that the U.S. leveraged loan market is $1.8 trillion, higher than the BIS estimated global figure of $1.4 trillion. Covenant lite means that lenders have very little in protection if borrowers default.
The majority of U.S. leveraged loans are below investment grade, that is, riskier debt from issuers rated B and B-, which means that these loans have a higher probability of default than investment grade bonds.
According to Claudio Borio, Head of the Monetary and Economic Department at the BIS “the credit standing of non-financial corporations in general, and the surge in leveraged loans in particular, represent a clear vulnerability.” In an economic downturn, as leverage loans start to be downgraded or default, their prices will fall, and they will become more illiquid. Numerous insurance companies, pension funds, and investment grade bond funds are not allowed to hold below investment grade instruments, so they have to sell them. This means that those banks, nonbanks, retail funds, ETFs, insurance companies, and pension funds that hold leverage loans will suffer losses.
Investors should be mindful that there are similarities as well as differences between CLOs and Collateralized Debt Obligations (CDOs), especially the way CDOs were structured before the financial crisis. According to BIS Senior Economists Sirio Aramonte and Fernando Avalos who wrote “Structured finance then and now: a comparison of CDOs and CLOs” for the latest BIS Quarterly, there are similarities between the “CLO market today and the CDO market then, including some that could give rise to financial distress. These include the deteriorating credit quality of CLOs’ underlying assets; the opacity of indirect exposures; the high concentration of banks’ direct holdings; and the uncertain resilience of senior tranches, which depend crucially on the correlation of losses among underlying loans.”
According to Borio “On the back of aggressive risk-taking and a search for yield, a growing portion of these bank loans to highly indebted firms have become the raw material for structured securitisations, known as collateralised loan obligations (CLOs). There are close parallels with the infamous collateralised debt obligations (CDOs), which resecuritised largely subprime mortgage-backed securities and played a central role during the GFC [Global Financial Crisis].” He also stated that while today’s picture “offers less cause for concern, financial distress cannot be entirely ruled out, especially in the light of the concentration of some known bank exposures, uncertainties about the size and distribution of indirect ones, and the surge in market finance post-crisis. Moreover, losses on these asset classes, and leveraged loans more generally, are likely to amplify any economic slowdown.”
Aramonte and Avalos did point to significant differences between today’s CLOs and the CDOs in the lead up to the crisis. “CLOs are less complex, avoiding the use of credit default swaps (CDS) and resecuritisations; they are little used as collateral in repo transactions; and they are less commonly funded by short-term borrowing than was the case for CDOs. In addition, there is better information about the direct exposures of banks.” They also explained that “When conditions in the housing market turned, the complexity and opacity of CDOs amplified financial stress. In contrast, CLOs are much less complex. Their collateral is diversified across firms and sectors, and the known incidence of synthetic collateral or resecuritisations is minimal.” According to them, Senior CLO tranches currently appear to benefit from larger loss-absorbing cushions than existed for CDOs. Equity and, in particular, mezzanine tranches make up larger shares of the capital structure of CLOs than they did for precrisis subprime CDOs. However, the actual protection afforded to senior tranches depends crucially on their sensitivity to default risk and, importantly, loss correlation risk.”
Importantly, Aramonte and Avalos also stated that “Uncertainty about loss correlations is less acute for CLOs, yet remains a risk. Given the relative simplicity of these vehicles and the long history of defaults on high-yield corporate debt, loss correlations for leveraged loans (and thus CLOs) can in principle be estimated with more confidence than for subprime mortgages. However, the unusually high share of deals with low investor protection could materially affect the timing and clustering of defaults, compromising the reliability of these estimations.”
My concern is that with two recent cuts in interest rates by the Federal Reserve, coupled with very low and even negative rates in both advanced and emerging markets, this environment will lead to more borrowing from leveraged borrowers and issuance of CLOs. This will likely happen because there is appetite from investors for higher yielding assets in order to make up for the very low interest rate environment.
Already, retail investors are possibly signaling a return to the leveraged loan markets (insert LCD). According to LCD News “after 43 weeks and nearly $27 billion of withdrawals, retain investors tip-toe back into the U.S. leveraged loan market, [into ETFs], a $24 million for the week ended on September 18.”
While we have reasonably good public data about how much banks and insurance companies are holding in leveraged loans and CLOs, the rest is everyone’s guess. By analyzing Bank of England and Federal Reserve data, I see that banks are the largest holders of leveraged loans and CLOs. Amongst banks, U.S. and Japanese banks, especially Norinchukin, are the most significant holders of leveraged loans and CLOs. ”Non-bank investors, such as hedge funds and insurance companies, are also major investors in CLOs, as they were in CDOs before the GFC,” said Aramonte and Avalos. “Ownership is more difficult to trace for non-bank investors than for banks. If non-bank investors were to experience losses on their CLO holdings, banks might be indirectly exposed. In particular, banks might be connected to those investors through legal and reputational ties, credit facilities or prime brokerage services. “Synthetic” prime brokerage, where hedge funds obtain leverage through derivatives with banks as counterparties, has grown rapidly in recent years. It also entails lower regulatory capital charges. Like banks’ off-balance sheet exposure to CDOs, which was a source of instability in 2007, banks’ prime brokerage exposure to CLO holders could result in larger losses than implied by direct exposures, creating heightened financial stress.” Additionally, the BIS economists explained that “Additional spillovers could arise from disruptions in market liquidity. Since the GFC, assets managed by fixed income mutual funds, including bank loan funds, have increased substantially. Some investment funds offering daily redemption of shares hold a small share of their assets in CLOs. At times of market distress, investors may rush to redeem their shares, quickly depleting the liquidity buffers held by such funds. This rush could result in fire sales and large price volatility, imposing mark-to-market losses on other intermediaries. Price volatility could also disrupt short term funding collateralised by CLOs, similarly to the “run on repo” in 2007. However, the use of CLOs as repo collateral appears minimal today, in contrast to the more widespread use of CDOs or MBS in the past.”
Unfortunately, in an economic downturn leveraged loans and CLOs will have significant capital implications for banks and insurance companies which have to increase capital to sustain unexpected losses when assets become riskier or more illiquid. Increasing capital in an economic downturn is not easy, so companies typically have to sell assets, which can lead to fire sales. Importantly, before an economic downturn comes, civil servants, nurses, firemen, teachers and policemen whose pensions have exposures to leveraged loans and CLOs will also take a hit as well. All individuals who have investments in ETFs and fixed income bond funds would do well to see what their exposure to leveraged loans and CLOs are.