The current credit cycle is approaching its peak that could "turn sharply," putting lenders and borrowers at risk at a time when the leveraged loan market is increasingly popular with investors, S&P Global Ratings said.
A report by S&P warned that the cycle could "turn sharply, particularly given global trade tensions and rising interest rates. Lenders and borrowers are, therefore, increasingly vulnerable to a dramatic and sustained change in risk appetite and capital flows," the report said.
The risks come at a time when private equity firms are ramping up investment in mergers and acquisitions — with the availability of cheap debt "critical" to the success of these investments, S&P said.
However, the search for yield "is eroding debtholder returns at a time of escalating risks, making the risk/return profile of many leveraged loans issued so far in 2018 the weakest since late 2008," said the report.
Lenders are also increasingly at risk as covenants associated with leveraged loans are weakening, offering fewer protections and "heightening their exposure to a turn in the credit cycle," it said.
"As we approach the latter stages of the current credit cycle, investor discipline has never been more important. The strong capital inflows and intense competition in deploying this capital are reducing returns at a time when risks are rising. For those lenders that fail to demand an adequate return for risk, and continue to pursue yield in the hope that benign credit conditions will continue, poor returns or losses are inevitable," the report said.
S&P Global added that history shows the worst debt deals are done at the best of times. "So, with the global economy strengthening in a near synchronized manner, now is the perfect time to be cautious."