What are leveraged loans, what are CLOs and should you worry?


  • Leveraged loans represent approximately $ 1.6 trillionon the forex market, and various financial experts have expressed concern over the booming sector.
  • These loans are generally grouped into complex credit instruments which are then purchased by pension funds and mutual funds, among others.
  • The market has been criticized for the weak protections afforded investors, some fearing that this will lead to major problems in the event of economic downturn or recession.

Leveraged loans have attracted a lot of heat in recent months.

These loans are, in simple terms, intended for riskier companies that have accumulated a large debt in relation to their profits. And the market for these loans has exploded.

Despite an extended period of low interest rates, 2017 was marked by a record number of leveraged loan issues, with 2018 followed by little, with total issuances of more than $ 700 billion. The total outstanding outstanding loans is estimated at between $ 1.4 trillion and $ 1.6 trillion.

A large number of companies, including Space X, Uber and Tesla, have taken advantage of the favorable terms recently used to borrow money to accumulate large debts, often with low legal requirements, called covenant-lite, which offer lenders limited protections.

And as the market grew, warnings grew louder and louder. Both the Federal Reserve and the Bank of England have expressed their concern over the market, while the Financial Stability Board (FSB) has announced that it will investigate the growing sector.

"The deterioration of underwriting standards for leveraged debt is becoming increasingly worrying," said Ron Temple, co-head of multi-asset and US equity manager at Lazard Asset Management, in an email to Business. insider.

The combination of growing indebtedness and decreasing protection of clauses "should be a warning sign for investors," he said. "As we assess the global credit landscape, this segment seems likely to be disrupted in the event of a downturn."

CLO, the next scary acronym?

These leveraged loans are often bundled with other similar loans and sold as Loans Bonds (CLOs). As noted by the Financial Policy Committee of the Bank of England: "Leveraged Loans are Generally Sold to Non-Bank Investors (Including Bonded Bonds with Collateral ), whose ability to sustain losses without materially affecting financing conditions is uncertain ".

Former banker William D. Cohan published an article in The New York Times that compared the repackaging of these loans with debt instruments that helped trigger the 2008 financial crisis. He wrote:

"Ten years ago, Wall Street's high-yield day-to-day investment consisted of mortgage-backed securities – residential mortgages that had been packaged and sold as" safe "investments around the world. Nowadays, so-called "safe" bankers and investment traders, the "secured loan obligation" or CLO "

More specifically, the problem is that:

  • Some of the companies that have contracted leveraged loans will not be able to handle the huge debt that they have accumulated and business bankruptcies will begin to increase in the event of a downturn.
  • According to the Leveraged Data & Commentary unit of S & P Global Market Intelligence, 85% of leveraged loans are now "covenant-lite", in that they do not respect the traditional obligations imposed on companies to keep certain financial benchmarks that protect investors who pay for them.
  • If the number of business failures increases, the less stringent lenders' protections associated with the "covenant-lite" agreements will see the ultimate owners of the debt struggling to recover their investments, thus hurting returns.
  • According to Fed Chairman Jerome Powell, investors in CLOs should bear the brunt of corporate bankruptcies, while JPMorgan Chase CEO Jamie Dimon said Wall Street banks were not if exposed to the market.
  • "At the moment, I feel that such losses are not likely to threaten the safety and soundness of the institutions at the heart of the system, but rather to affect investors," Powell said at the end of the year. last year.
  • So who are the investors in the CLOs? Think about hedge funds, mutual funds and pension funds. In other words, writes Cohan, "you and me".

The market could continue to grow

The leveraged loan market is only a major problem if companies are facing economic difficulties. And the market could continue to grow for a while longer. Opinions on a potential recession in the United States vary, but in general, signals suggest a potential slowdown by 2020.

The other problem to consider is the broader economic context of the rise in leveraged loans. The limited attractiveness of US Treasury securities and other government bonds has prompted investors to seek better returns for other parts of the market. This seems unlikely given the Fed's decision not to raise rates on Wednesday and say it would keep them static for the remainder of 2019.

Recent figures indicate that the leveraged loan market has picked up again, with February issues rising to $ 61.2 billion, up 50% from January, but slightly down compared with the same month in 2018, according to Reuters LPC. CLO's emissions amounted to $ 13 billion according to LCD.

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