- 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.
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.
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 $US1.3 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.
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