Warnings over leveraged loans are not mere fear-mongering

Anyone sounding a warning about high debt levels in 2019 is sure to be accused of paranoia. Giving too much weight to a recent extreme event, while neglecting the larger picture, is a common and costly investing mistake. The crisis of 10 years ago was the most extreme event of most market participants’ lifetimes. It is therefore natural that many are waiting for that bit of history to repeat itself, seeing highly contagious, debt-driven asset-price collapses around every corner.

But, as the old joke has it, even if you are paranoid, it still might be that everyone is out to get you. As the Financial Times’ Debt Machine series has shown, worries that there are new dangers building in the credit markets cannot be dismissed as mere fear-mongering.

It not just that a weighty list of institutions have lately cautioned about leveraged loans — those loans extended to already indebted or low-rated companies. The US Federal Reserve, the Bank of England, the IMF, the Bank of International Settlements have all offered red flags. Behind these warnings are hard facts about the growth and sheer size of this market, and adjacent ones.

The amount of outstanding leveraged loans has doubled from its peak before the financial crisis to almost $1.2tn. For a third of the loans issued last year, borrowers’ debt exceeded six times cash flow — the risk threshold the US Treasury proposed five years ago. Four-fifths of the market is now “covenant light,” meaning that lender protections have been largely ripped out of contracts. Higher leverage and frail covenants are now pervasive even in the formerly conservative (and still illiquid) European loans market.

Pile on top of all this debt another market that has doubled in the last decade, where non-bank lenders such as private equity funds and special investment vehicles place debt directly with companies. The $700bn “private debt” market has seen loan yields collapse in the last few years, not because credit quality is getting better, but because investor demand has increased. Finally, new online lending platforms are now a significant source of credit to small businesses, filling in for banks, which have pulled back. But there is poor visibility into how fast this form of debt is growing, and regulation is light.

It is folly to suggest a fixed threshold beyond which debt becomes unsustainable, or to try to predict the timing of debt cycles. We know only that debt cannot grow faster than its host economy indefinitely, and that debt accumulation driven more by demand from investors than demand from borrowers is particularly unstable.

The endgame, on standard models, comes when debt goes to support uneconomic projects, borrowers miss payments, spooked lenders pull back, and suddenly even borrowers with sound investments to make, find credit scarce.

There is a debate about whether the increase in corporate debt in the last decade has funded much investment at all, or just added leverage to balance sheets through share buybacks or private-equity buyouts. To the degree the current credit expansion has been investment-light, investment is unlikely to collapse if credit contracts.

Even if that is so, however, when high debt collides with a slowing economy or inflation, corporate balance sheets will have to be restructured and investors will take losses, with potentially serious follow-on effects for the economy. At the very least, as one loan investor recently put it, “the credit market is likely to have high dispersion of returns.” In layman’s terms: less sophisticated investors are going to get stung. The US economy may not be nearing a downturn, but that changes the timing of the pain, not its severity.