INSIGHT FROM OUR CHIEF RISK OFFICER
the level of high-yield bonds outstanding. More concerning is that the average leverage in the underlying senior secured loans has risen from a little over 2x cash flow to 4x cash flow since 2000. Further, the total debt in these borrowers has risen from 3.7x to 5x... with much of the remaining debt in many cases being mortgages or advances against working capital, which is effectively senior to the first lien loans that we are discussing. The secular concerns of this leverage are exacerbated by the way that this remarkable growth in the magnitude and availability of highly levered loans/credit has driven up the valuations of the underlying companies to over 10x cash flow on average (up from 8x in 2010). Again, heightened valuations, just like heightened leverage, are adding to that pile of tinder... and to the potential size and severity of an economic downturn. The final piece to the puzzle in the world of levered loans is that while one typically thinks of a loan as a banking activity, these are not. In fact, the leverage in these borrowings frequently exceeds what the regulators would allow. Instead, 95% of these loans are owned by institutional investors, including many foreign institutions, who are drawn to the idea of floating rate assets with no duration risk and relatively high yields. In fact, more than half of these loans are in the form of collateralized loan obligations (CLOs)... a structured credit “solution” to the quandary that most investors are uncomfortable with – the level of risk in the underlying loans. This allows them to derive comfort from their investment-grade investment in these structures, supported by a sliver of capital that
These ultra-high debt levels in investment- grade bonds have created an environment with substantially more susceptibility to disruption... and deep implications for our economy in the next recession. In essence, a forest full of dried piles of tinder (and not the dating app kind) waiting for a spark. Where is that spark likely to come from? The world of non-investment-grade corporates (high-yield and leveraged loans) . Strangely, unlike 1989, it will not be led by high-yield bonds, as to date that is the one area of the public bond markets where issuer leverage and issuance have not risen. Instead, it will be led by the levered-loan phenomenon... A gift from the Basel 1 banking regulation of 1988, which effectively created a shadow-banking system by pushing assets off of bank balance sheets.
The levered-loan market effectively began in the late 1990s, as investors were searching for yield through structured-credit instruments, and banks were actively discouraged by regulators from holding riskier paper on their balance sheets. From those modest beginnings, levered-loan outstandings now approach $1.5 trillion and exceed
70 November 2018
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