The Leveraged Loan Ticking Time Bomb

In 2008, the subprime mortgage market crashed and led to a severe global recession. History may be repeating itself.

The $1.3 trillion leveraged loan market appears ready to threaten the U.S. financial system and investor portfolios.

Leveraged loans are made by lending syndicates to speculative companies with junk grade credit. The money is often used to finance private-equity transactions, or M&A deals, leveraged buyouts, or to refinance existing debt or recapitalize a balance sheet.

Higher risk means greater returns, and investors have been gorging on the loans.

More than $11 billion has flowed into sixty-four bank loan mutual funds so far this year, according to data from Morningstar, which observed that total assets in the funds now top $144 billion.

The leveraged loan market is now slightly bigger than the high-yield bond market, which poses its own set of perils for investors.

The problem for retail investors is that leveraged loans are very risky credits and are unregulated by the Securities and Exchange Commission.  The leveraged loans are governed by covenants that stipulate what provisions, if any, borrowers must follow to preserve the interests of lenders.  Usually they involve maintaining interest coverage and leverage ratios, as well as preserving the position of lenders in the company’s capital structure.

Knowledgeable sources have recently expressed concerns about the market for such loans, particularly weakness in the all-important debt covenants.

The quality of protections built into the terms of North American leveraged loans weakened to their worst-ever level in the 2018 third quarter, Moody’s Investors Service said last week, warning that the move is exposing investors to higher levels of risk, according to an article by MarketWatch.

If market conditions deteriorate, these loans are more likely to end up in default as there are fewer protections to stop them, MarketWatch reported.

“Weak covenant protections persist as demand for leveraged loans continues to surpass that for high-yield bonds,” a senior Moody’s analyst wrote in a note. “Strong demand allows borrowers to negotiate highly flexible covenant provisions, a trend we expect to continue and to leave investors exposed to greater risks than ever before.”

Another warning on leveraged loans came from the Federal Reserve banking regulator who told an industry conference that the Fed was taking a close look at banks’ risk management.

“Activity in the U.S. market has boomed, and it is U.S. officials leading the warning calls,” according to the Wall Street Journal. “Standards in the leveraged loan market have been slipping as more aggressive private-equity deals have pushed debt multiples higher and eviscerated the traditional protections, known as covenants, that allow lenders to intervene if borrowers start to struggle.”

Janet Yellen, former Fed Chair, also raised concerns about the market in an interview discussing the growth of such loans, loosening of standards and the role of non-banks in the market.

And Senator Elizabeth Warren, Dem.- Mass., the scourge of Wall Street, was blunt in her concerns that the Federal Reserve and their fellow watchdogs of the financial system are overlooking a dangerous buildup of loans for companies that are already deeply in debt.  She warned that leveraged loans helped undermine the financial system in 2008 and are building up again.

“I’m not sure that I see much distinction between what you’re doing now and what the Fed was doing in pre-2008, and I think that’s deeply worrisome,” Ms. Warren said, according to CNBC.com. “I’m very concerned that the Fed dropped the ball before and they may be dropping it one more time.”

Investors need to examine their portfolios to see if they are in risky leveraged loans and discuss their concerns with their financial advisors.

A boom in investor fraud lawsuits involving leveraged loans is likely to occur in 2019. Buyer beware.

Zamansky LLC is a New York law firm which represents investors in court and arbitration cases against securities brokerage firms and issuers.  The firm may represent investors in cases against companies mentioned in this blog.  Zamansky LLC also represents investors in arbitration cases against UBS and other brokerage firms regarding Puerto Rico bonds and UBS closed end bond funds and other investments. https://www.puertoricobondfundsattorney.com/