'Carry on': Corporate debt risks are rising, but Barclays says the market will outperform in 2019

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  • The sharp increase in leveraged loans has “caught the eye of financial and political leaders,” Barclays says.
  • However, the bank expects leveraged loans to outperform other corporate bond assets in 2019.

“If you want something to worry about, this is it.”

That was the warning issued in October by JP Morgan’s Anton Pil, on the buildup of “covenant-lite” lending in corporate bond markets — loans which give the issuer less rights in the event of a default.

In a research note on corporate debt, Barclays noted the rise in leverage has “caught the eye of financial and political leaders”.

Despite that, they argue the risk of a systemic credit downgrade in leveraged loans is more of a medium term story.

As far as 2019 is concerned, their advice is “carry on”. In fact, investments in leveraged loans “will be able to produce similar returns or slightly higher than in 2018”.

A key factor in their outlook is that leveraged loans trading at distressed levels are holding near recent lows:

Source: Barclays

Combined with Barclays analysis of specific sectors or companies which may be more at-risk, the results suggest “little acceleration of defaults in the year ahead”.

Around $US122 billion of leveraged loans have been issued since January, which puts 2018 on track to be a record year.

Along with the increased issuance, leveraged loans have also been among the best performing asset classes in corporate bond markets.

The leveraged loan market returned “3.46% through November 23,” comfortably outpacing high-yield and investment-grade corporate bonds — both of which had negative returns.

Barclays said returns on leveraged loans were helped by an environment of rising interest rates, which pushed up the London Inter-bank Offer Rate (LIBOR) — the global benchmark used to price corporate debt.

Looking ahead, “we forecast total returns of 4.5-5.5%, and excess returns to be 1.5-2.5% for US loans in 2019,” Barclay’s said.

One “less appreciated risk” to look out for is that leveraged loans are prone to downgrades if US corporate earnings growth slows.

And longer-term, “higher corporate leverage and weaker covenants will hurt recoveries over the cycle”.

But if a significant repricing in leveraged loan markets does eventuate, Barclays said another financial crisis is unlikely.

“Recoveries are likely to be lower in the next default cycle, although volatility should still be much less than in 2008-09, thanks to a lack of recourse leverage”.

Full recourse loans give the lender right to additional assets of the borrower, if money is still owed after the loan collateral is paid back.

Regardless, “we think that eventuality will not be realised in 2019, and that loans will produce similar returns or slightly higher than in 2018”.

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