There hasn't been this much risky corporate debt in years. The Fed is sounding the alarm about what that could mean for the economy.

  • In 2018, the amount of leveraged loans increased by 20% to above recent peaks in 2007 and 2014.
  • The Federal Reserve this week flagged the sharp rise as a potential risk to the financial system.
  • But institutions appear more resilient than before the financial crisis.

A rapid rise in levels of risky corporate debt has emerged as a top vulnerability in the world’s largest economy.

Leveraged lending in the US jumped by a fifth to $US1.1 trillion in 2018, above peaks seen during the financial crisis, the Federal Reserve said in a semi-annual report out Monday.

That was particularly concerning because the largest increases were concentrated among the riskiest firms, which have lower credit ratings and already large amounts of debt. Credit standards for business loans appear to have loosened over the past six months.

Default rates in leveraged lending remain relatively low, but officials cautioned that this could change in the case of a slowdown.

“Even without a sharp decrease in credit availability, any weakening of economic activity could boost default rates and lead to credit-related contractions to employment and investment among these businesses,” the report said.

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While the economy grew at a far faster pace than was expected in the first quarter, forecasters said underlying trends pointed to cooler growth in the coming months. Officials highlighted a series of strains that could lead growth to falter, including global-trade tensions and slowing activity in Europe and China.

Collateralized loan obligations, which are bundles of leveraged loans sold in tranches, reached record levels in 2018 and accounted for more than half of outstanding leveraged loans. Yet the Fed noted that this type of loan has become far more stable than in the run-up to the Great Recession a decade ago.

“Compared with the investment vehicles associated with subprime mortgages in the financial crisis, CLOs are structured in a way that avoids run risk,” the report said.

It’s not unusual to worry about a boom-and-bust situation at this point in the business cycle, said Ryan Sweet, an economist at Moody’s Analytics. The expansion that began in 2009 is set to become the longest in history this July.

“While there are significant differences between leveraged lending and subprime mortgage lending, the similarities are eerie,” he said.

In November, the Fed flagged similar risks to nonfinancial corporate borrowing.

“The good news is that because everyone is talking about the leverage loan market, including regulators, odds are this won’t kill this expansion,” Sweet said.

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