US corporate debt
Secondly, securitization was ever present in the 2000s, where an explosion in the bundling up of securitized mortgages into collateralized debt obligations (CDOs) went on to play an infamous role in the 2008 financial crash. Therefore, collateralized loan obligations (CLOs) found in the leveraged-loan market immediately sound dubious. CLOs are portfolios of predominantly leveraged loans that are securitized and managed as a fund. 24 They are typically made from a pool of 150 to 250 loans and are normally backed by corporate loans with low credit rating. 25 These debts are divided into tranches which face varying risks from default. Thirdly, in 2013 the Federal Reserve issued guidance that banks should avoid making loans that would see companies’ debts exceed six times EBITDA in an attempt to slow the growth of corporate debt. However, in November 2021 it was found that ‘33 percent of US leveraged loans issued so far this year had a ratio of debt to [EBITDA] that exceeded six times’ according to LCD data, 26 showing that the guidance is now routinely ignored. Despite these three points of comparison, the leveraged-loan market has some key differences to the subprime markets of the mid-2000s. 27 The securities in the mid-2000s typically contained thousands of mortgages; and those selling them on had little interest in providing the details of these mortgages, they simply wanted to sell off their loans in order to create room on their balance sheet. CLOs contain fewer debts, and their issuers know more about the debtors and each credit is analysed individually by hundreds of analysts at firms around the globe. 28 Furthermore, unlike the housing boom, which included securitizations-of-securitizations, CLOs have long been the asset of choice for investors wanting exposure to leveraged loans since they have a solid record. No AAA or AA rated American CLO has ever defaulted and only one American CLO defaulted in 2020. 29 But with COVID-19 impacting credit quality globally, in 2020, ‘10.6 percent of CLO ratings were lowered, the greatest drop in ratings since 2009’, 30 risking a wave of downgrades to junk bond status. So, should we really be worried? America’s banks are not disturbingly exposed to leveraged loans like they were to CDOs. The Bank of England estimates that they provide only about 20% of CLO funds, with American insurers providing another 14%. 31 This is vastly different to the mid-2000s where all CDOs were provided by American banks. It is also important to note that American banks typically only deal with the highest-quality securities. The lower quality tranches of CLO debt – those that would suffer losses should defaults rise – are mostly held by hedge funds, credit investors and the CLO managers themselves. 32 Even if a lot of CLO debt defaulted, due to the size of the economy, access to credit may not be a concern.
That said, defaults on loans are not the only way for corporate debt to upset the financial system. In 2012, about 40% of investment grade corporate bonds, by value, were just one notch above junk status.
24 Kollmorgen, ‘ CLOs: How they work ’. 25 Segal, Collateralized Loan Obligations ’. 26 Rennison, ‘ US borrowers breach loan limit ’. 27 The Economist , ‘America’s corporate debt mountain’. 28 Kollmorgen, ‘ CLOs vs CDOs ’. 29 S&P Global Ratings, ‘ 2020 annual CLO default and rating ’. 30 Ibid. 31 The Economist , ‘America’s corporate debt mountain’. 32 Ibid.
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