Leveraged Loans – a Small but Important Piece of the US Financial System

Much has been written lately on the leveraged loan market. We believe Federal Reserve Chairman Powell aptly summarized the current state of the leveraged loan market in a November 2018 speech to the Economic Club of New York: “The question for financial stability is whether elevated business bankruptcies and outsized losses would risk undermining the ability of the financial system to perform its critical functions on behalf of households and businesses. For now, my view is that such losses are unlikely to pose a threat to the safety and soundness of the institutions at the core of the system and, instead, are likely to fall on investors in vehicles like collateralized loan obligations with stable funding that present little threat of damaging fire sales.”

SIFMA recently published a report on leveraged loans which includes frequently asked questions and a fact sheet.

Leveraged Lending FAQ and Fact SheetHighlights of the report include:

  • Leveraged Loans are a type of syndicated loan made to below investment grade companies, i.e. companies with a credit rating below BBB-/Baa3. Many well-known companies fall into this category, including Burger King, Chrysler, Dell, American Airlines and Avis.  According to the Loan Syndications and Trading Association (LSTA), over 70% of companies in America hold below investment grade ratings.
  • The leveraged loan market is a small but important piece of the U.S. financial system. In terms of size, the mortgage market has roughly $10 trillion in mortgage loans outstanding, and the broader fixed-income markets have a total outstanding of over $42 trillion, according to data from the Federal Reserve and SIFMA. There are $1.7 trillion in leveraged loans outstanding, according to the LSTA.
  • Said another way, leveraged lending is small in comparison at 4.1% of total U.S. fixed income securities markets outstanding, or 0.18x MBS and 0.19x corporate bonds. While leveraged lending and CLO issuance continues to grow, both markets remain much smaller in size than various fixed income securities segments.
  • CLOs are often cast as harbingers of systemic risk, but their historical performance through one of the most challenging economic cycles in modern history shows this is not the case. CLOs have stable funding, terms of loans can be renegotiated and, accordingly, they weathered the credit crisis with remarkable strength. According to Moody’s, of the 5,176 CLO tranches outstanding between 1996 and 2014, only 1.1% became “impaired.” No senior tranches – those rated Aa or Aaa – suffered losses.
  • CLO loss rates are far below those for residential mortgage-backed securities (>25%), CDOs (35%) or even comparably rated corporate bonds (16% for BB-rated corporate bonds). Leveraged lending default rates peaked in 2014 at >4.5% but are down to 1.6% as of November 2018.  Companies typically default because they cannot pay or service their debt. Current interest coverage ratios are very high – near record levels for loans in the S+P/LSTA index. At year-end 2018, the default rate for leveraged loans was 1.6%, with some rating agencies projecting this rate will drop in 2019.

The full report is available here.

Kenneth E. Bentsen, Jr. is president and CEO of SIFMA, the voice of the nation’s securities industry. He is also CEO of the Global Financial Markets Association (GFMA), of which SIFMA is the U.S. regional member.