Podcast Summary
Investors seeking higher yields turn to riskier leveraged loans: Amid historically low interest rates, investors shift towards leveraged loans for better returns, despite added complexities and risks
The leveraged loan market, which involves investing in loans to riskier companies, has become increasingly popular among investors due to historically low interest rates. With yields from traditional investments like government bonds no longer providing decent returns, investors have turned to riskier assets like leveraged loans to earn higher returns. Leveraged loans function similarly to regular loans, with the borrowing company serving as collateral for the loan. However, these loans come with additional complexities and risks, leading some regulators to express concerns about the potential impact on the financial system. Before the financial crisis, investors could earn decent yields from safer investments. But after the crisis, with interest rates at historic lows, investors had to seek out riskier assets like leveraged loans to earn acceptable returns. These loans, typically given to already indebted companies, offer higher returns due to the increased risk. Essentially, a leveraged loan is a loan where the borrowing company's assets serve as collateral for the loan. While similar to regular loans, leveraged loans come with added complexities and risks, making them a topic of concern for some regulators.
Leverage loans vs. mortgages: Same concept, different interest rates: Leverage loans have floating rates tied to benchmarks, banks sell them to investors, and market conditions impact interest rates.
While loan documents may vary between companies, the fundamental concept remains the same: a loan secured by a company's assets. However, a key distinction between a leverage loan and a mortgage is the interest rate. Leverage loans have floating rates that follow benchmark interest rates like LIBOR, meaning a company's interest rate can rise or fall based on market conditions. After the loan is agreed upon between the bank and the company, the bank tries to sell the loan to investors, acting as an administrator. This shift in lending post-financial crisis has resulted in banks holding fewer leveraged loans and investors carrying the risk instead. For instance, a company like Neiman Marcus or PetSmart would negotiate loan terms with a bank, who then attempts to sell the loan to investors. The incentives involved have changed, with banks focusing more on underwriting and selling loans rather than holding them on their balance sheets.
Shift in power from banks to private equity firms: Private equity firms now have more favorable terms due to increased investor demand, leading to relaxed lending standards and lower borrowing costs for sponsors, deteriorating underwriting standards in the leveraged loan market.
The market for leveraged loans has seen a significant shift in power from banks to private equity firms due to increased investor demand. This has led to more favorable terms for private equity sponsors, including relaxed lending standards and lower borrowing costs. As a result, banks have less incentive to maintain strict lending standards since they no longer hold these assets on their balance sheets. This trend has contributed to a reach for yield and deterioration in underwriting standards in the leveraged loan market. It is now a challenge for regulatory bodies to ensure underwriting standards are raised to minimize risks, as a large portion of these loans originate outside the regulated banking sector.
Concerns over leverage loans market's investor protections and high leverage levels: The leverage loans market, exceeding high yield bonds, raises concerns due to deteriorating investor protections, high leverage, and easing lending standards, potentially leading to lower recovery rates and systemic risks.
The leverage loans market, which surpassed even that of high yield bonds in 2018, has raised concerns among regulators due to the deteriorating investor protections, high leverage levels, and easing lending standards, specifically the rise of cov-lite loans without maintenance covenants. These factors could potentially lead to lower recovery rates during a default cycle and have systemic consequences for the credit market, although it's argued that the risks are not held primarily by banks and the market is not as large as the one that contributed to the financial crisis. However, the lack of maintenance covenants means investors might not be able to address potential issues early on, which could result in significant losses when economic pressures build.
Financial maintenance covenants don't guarantee prevention of defaults: PE firms and ratings agencies warn that these covenants do not ensure investment in sound companies, and retail investors' withdrawals can cause market instability
While financial maintenance covenants in leveraged loans can provide early warning signs of potential financial distress, they do not guarantee prevention of defaults. PE firms argue that these covenants do not save you from lending to a bad company. Ratings agencies also suggest that even if a company does not default, investors may recover less in such cases. Retail money, which is only about 15% of the market, has grown significantly in leveraged loans, but the majority of the investment comes from permanent vehicles like Collateralized Loan Obligations (CLOs), which are less likely to withdraw funds rapidly during market stress. This stability of investment in the market can help mitigate the risk of a mass exodus of funds, which can intensify market problems. The concern lies with the retail money that can be easily withdrawn, as seen in December 2022 when $4 billion was pulled out of leverage loans, causing loan prices to drop substantially.
Leverage loan market volatility signals retail investors' exit: Institutional investors view leverage loan market volatility as a positive sign of retail investors exiting, but new risky transactions may still emerge, and the impact on non-bank players is uncertain.
The leverage loan market experienced volatility towards the end of 2022, with some deals being pulled or sold at less generous terms due to trouble in selling these loans. Institutional investors saw this as a positive sign, as it meant retail investors, or less committed money, were exiting the market. However, there's concern that even if attention is paid to mitigating risks in the leverage loan market, new transactions and products may still emerge that could potentially be risky. The financial crisis serves as a reminder that it's difficult to predict what may cause unexpected risks. Despite this, the current system where banks originate but don't hold onto these loans, improving their funding picture, is a positive development. However, the extent to which this applies to other players in the market, such as asset managers, hedge funds, and private equity funds, is unclear. Ultimately, their job is to make investments, and taking risks is a part of that. The reporting from Colby and Joe is part of a bigger FT series called "The Debt Machine," exploring how lenders outside of the conventional banking system help companies get deeper into debt and the potential consequences. You can find it at ft.com/debtmachine.
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