LONDON, Jan 21 (LPC) - The chorus of warnings about leveraged loans as a potential threat to financial stability grew louder after the Bank of England expressed concern again that the market might be heading for trouble.
But global demand for yield remains so high, that unless tighter regulation is imposed, the leveraged loan market will keep growing and covenants keep loosening, analysts and investors said.
BoE governor Mark Carney ramped up the pressure on leveraged loans last Wednesday, telling a committee of lawmakers that its growth echoed the sub-prime market and the deterioration of underwriting standards seen before the global financial crisis a decade ago.
Carney’s comment comes at a time when leveraged loans issuance ballooned to US$1.47trn globally last year, marking the second record year since the financial crisis following US$1.71trn in 2017.
He did, however, acknowledge an “adjustment ... greater focus on underwriting” in the market in recent months.
In September, the Bank for International Settlements flagged the global boom in leveraged loans as a problem along with deteriorating credit quality, and was followed in October by similar comments by the BoE and Federal Reserve.
The International Monetary Fund weighed in during November, as the unprecedented criticism by international organisations mounted.
Increasing criticism raises the prospect of increased regulation, but previous attempts that focused on curbing leverage levels have had limited results due to differing approaches by international regulators.
The ECB introduced guidelines in 2017, similar to those seen in the US, that limit leverage levels to six times on adjusted Ebitda. However, as Ebitda was defined so broadly, leverage levels increased.
“The ECB’s leveraged lending guidelines have had very little impact,” said Peter Firth, an associate managing director in the corporate finance group at Moody’s.
The latest focus by regulators on underwriting standards goes to the heart of the booming market, where global demand for yield has seen a wave of money flow into the market.
This has spurred record volume in covenant-lite loans and encouraged sponsors to inflate Ebitda figures through add-backs and estimated cost savings. About three-quarters of leveraged loans are now covenant-lite.
Few see that trend reversing in the short-term as the continued growth of CLO funds, the biggest buyers of leveraged loans, and liquidity from separately managed accounts keeps demand high.
“We expect demand for leveraged loans to continue outstripping supply. This has been the major factor driving progressively weakening capital structures and weaker contractual protections for investors - neither of which are likely to materially improve anytime soon,” Firth said.
The appeal of floating-rate debt in a rising interest rate environment and higher returns means CLOs are popular among investors, including pension funds. European CLO issuance of €27.29bn in 2018 set a post-crisis record.
“In the long term, the market will be more regulated,” a banker said.
Some buyside investors would like to see better regulation of underwriting standards as the market expects a late-cycle economic downturn.
“If the BoE is worried about the leveraged loan market they should impose some underwriting standards, such as limiting pro forma adjustments on Ebitda,” an investor said. “Everything that can improve market risk is welcome.” (Editing by Christopher Mangham)