Federal Reserve officials have finally caught on to the leveraged-loan boom.
In minutes of the Federal Open Market Committee’s September meeting, policy makers made explicit for the first time that they’re watching for any hint of risks to financial stability stemming from the more than $1 trillion market for U.S. leveraged loans. They’re late to pile on. There’s been no shortage of warnings from fixed-income traders and credit analysts who track investor protections. Just last month, my Bloomberg Opinion colleague Mark Whitehouse wrote a column that called the loans “one likely cause of the next crisis.” The Bank for International Settlements effectively said the same thing a week later. Moody’s Investors Service raised concerns in August. And, perhaps most important, former Fed Chair Janet Yellen said last month that “regulators should sound the alarm.”
Here’s what the Fed minutes said:
“Some participants commented about the continued growth in leveraged loans, the loosening of terms and standards on these loans, or the growth of this activity in the nonbank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability.”
While not terribly illuminating, minutes from August simply stated that “gross issuance of corporate bonds and institutional leveraged loans picked up in May and stayed strong in June.” Before that, it was that “issuance of institutional leveraged loans was strong in April and May; meanwhile, corporate bond issuance was weak.” In August, language on risks to the financial system didn’t include the words “leveraged loans.” Participants simply “noted that asset valuations remained elevated and corporate borrowing terms remained easy.”
There’s no shortage of hand-wringing over this type of borrowing. In fact, just before the Fed minutes were released, the first question posed to panelists at an Eaton Vance Corp. event was whether they see the growth in corporate leverage as a systemic risk (they said not yet). The fact that leveraged loans are increasingly packaged into collateralized loan obligations — which sound a lot like the collateralized debt obligations that contributed to the financial crisis — only adds to the angst.
Leveraged loans have rarely had a down day in recent months as demand remains robust
Leveraged loans are popular because they carry floating interest rates and have generally carried more investor protection than typical high-yield bonds. But those covenants are disappearing because demand is so strong. That, in turn, allows companies to sneak through favorable terms for themselves if their finances sour. According to Moody’s, overall covenant quality is weaker now than in 2007 across every risk category.
Moody’s has already stated that the average recovery rate is going to be worse in the next downturn than it was in 2008, but it’s not clear that investors know that. Case in point: the S&P/LSTA Leveraged Loan Total Return Index has rarely had a down day in the past few months, including during the recent bout of stock-market turbulence. While few were calling the move in equities anything more than a correction, leveraged loans’ resilience gave them an aura of invincibility that will most likely be shattered when the credit cycle turns.
The Fed has a mixed record at best when it comes to pinpointing the looming risks to financial stability. Getting leveraged loans on its radar is a good start this time around.