Optimistic accounting and weakening deal terms have money managers and official institutions sounding warning bells on leveraged finance.
In recent months, a number of institutions and central banks have highlighted concerns over the leveraged loan market, which the International Monetary Fund tallied as a $1.3 trillion global market.
On its website last month, the IMF outlined its worries in a blog post.
"At this late stage of the credit cycle, with signs reminiscent of past episodes of excess, it's vital to ask: How vulnerable is the leveraged loan market to a sudden shift in investor risk appetite?" the IMF asked.
Leveraged loan issuance has reached about $745 billion so far this year, according to the IMF, although figures do show a slowdown in October. That compares with last year's record $788 billion in issuance, which surpassed a pre-crisis high of $762 billion in 2007.
"It is not only the sheer volume of debt that is causing concern. Underwriting standards and credit quality have deteriorated," the IMF wrote. It noted that new deals include fewer investor protections, with a proliferation of so-called covenant-light loans, and that more than half of this year's total issuance "involves money borrowed to fund mergers and acquisitions and leveraged buyouts, pay dividends, and buy back shares from investor(s) — in other words, for financial risk-taking rather than plain-vanilla productive investment," the IMF wrote.
Institutional investors' involvement in the leveraged loan market also worries the IMF, which said these institutions now hold about $1.1 trillion of leveraged loans in the U.S., a figure that has almost doubled since before the global financial crisis.
Institutional bank loan assets under management totaled $672.4 billion as of Sept. 30, according to data from eVestment LLC, down 5.2% vs. Sept. 30, 2017, but up 14.4% from Sept. 30, 2016.
Money managers added that interest in leveraged finance, in particular loans, continues — particularly given the returns the strategies offer.
Christine Farquhar, global head of the credit investment group at Cambridge Associates LLC in London, said European and U.S. leveraged loans turned in 12-month returns of 4% to 5% in local currency terms, respectively. Data from eVestment showed a 1.89% return for the quarter ended Sept. 30, compared with 1.34% for the same quarter last year.
"I definitely see a growing interest from institutions, even some smaller ones, to invest in leveraged finance, in particular loans," said Thierry de Vergnes, European head of bank loans at Amundi in Paris. "Low volatility and attractive yield seem to be the key features these investors are looking for. There is an impressive momentum for leveraged loans these days, stronger than I have seen for a long time."
Other organizations also have sounded the alarm on the leveraged loan market, including the U.S. Office of the Comptroller of the Currency, which highlighted the issue of "eased loan underwriting standards, particularly in leveraged loans" in its Semiannual Risk Perspective for Fall 2018. The Bank of England's Financial Policy Committee, in a statement from its Oct. 3 meeting, said it is "concerned by the rapid growth of leveraged lending." The committee said the global leveraged loan market "is larger than — and growing as quickly as — the U.S. subprime mortgage market was in 2006."
The FPC added: "In common with the U.S. and Europe, high investor demand has driven strong growth in U.K. leveraged loans," with terms loosening. The committee is assessing the implications of rapid growth for both banks and non-banks in leveraged lending.
Money managers, too, are showing a red flag for parts of leveraged finance.
Demand for the asset class has remained strong despite signs the credit cycle is reaching its last stage and that these loans are less robust than in recent years, said Andrew Jackson, London-based head of fixed income at Hermes Investment Management.
"This demand predominantly emanates from two things: the appeal of floating coupons on (leveraged) loans in a rising-rate environment and the rapacious appetite of the (collateralized loan obligation) structures, which themselves have experienced record levels of issuance," he said. "Some have argued that these volumes of activity, in and of themselves, present systemic risk; we find comfort in that the issuance is matched by a CLO demand base that is a patient, non-mark-to-market investor with locked-in liabilities."
The real issue, said Mr. Jackson, "is the deteriorating underwriting standards on leverage, covenants and adjustments." Hermes does not split out assets under management of specific asset classes.
The manager's biggest concern is an increasingly prevalent practice by companies of adjusting earnings before interest, taxes, depreciation and amortization figures "in more and more generous ways, which get us further from mirroring genuine cash-flow generation," Mr. Jackson said.
The fact that covenant-light deals are increasingly prevalent, and that leverage levels are back to those last seen in 2007, also are concerns. "All of the above leads us to be cautious on the asset class," concluded Mr. Jackson, adding that rigorous credit selection is therefore necessary.
The quality of earnings and loan contracts was noted by Amundi's Mr. de Vergnes. "While it has always been common to 'adjust' EBITDA numbers to factor in specific events, it is true that some issuers are sometimes more optimistic in their adjustments, and in this respect the quality of earnings has deteriorated," he said.
Peter Aspbury, London-based managing director and head of European high yield at J.P. Morgan Asset Management (JPM), agreed credit risk has increased to a greater degree in leveraged loans relative to high-yield bonds.
"This is mainly evident in the use of proceeds of debt issuance and in covenant quality. A far heavier weight of issuance in the loan market has been deployed for riskier uses, namely (mergers and acquisitions) and dividend payments," Mr. Aspbury said. High-yield bond proceeds have been used more so for the refinancing of existing indebtedness, he said.
While executives at JPMAM expect leveraged lending to fall next year, "this is not a reason to be any less concerned about credit quality," Mr. Aspbury said.
Another consideration in the leveraged finance market is around issuance itself. The Association for Financial Markets in Europe's third-quarter report on European leveraged finance issuance showed a decrease to €44.8 billion ($50.8 billion) for the three months ended Sept. 30, down 26.2% vs. the previous quarter and down 13.9% from the third quarter of 2017. AFME added that issuance volume for the this year's third quarter was the lowest quarterly total since the first quarter of 2016.
And Moody's Investors Service's monthly High Yield Interest newsletter, published Nov. 21, said October's leveraged finance issuance was $5.3 billion — 30% of the total issued in September and 14% of the volumes reached in October 2017.
This lower issuance was attributed to several factors. Amundi's Mr. de Vergnes said it is due to a "pause after an exceptionally strong issuance volume in 2017" because there has not been the same volume of refinancings to take advantage of lower margins as in 2017. There also has been fewer dividend recapitalizations than last year.
"In 2018, a much larger portion of the market of leveraged loans is about financing M&A transactions," Mr. de Vergnes said. "This is positive for the loan asset class because it means generally higher equity contribution in the transactions, meaning the debt will be better positioned in case of economic slowdown."
CLOs could decline
Cambridge Associates' Ms. Farquhar said there is a risk that CLO issuance could decline should U.S. interest rates "rise far enough to choke off the capital that funds the most risky part of the capital structure."
However, she said less supply "is not so much a systemic risk but more a cyclical phenomenon where markets will likely adjust, as usual, through the repricing of existing and new issuance."
But there might be implications for financial markets. "Lower issuance is a positive technical for asset prices," J.P. Morgan's Mr. Aspbury said. "If demand stays at least constant, then borrowing costs should be driven lower. However, if lower issuance ends up being a consequence of lower demand for credit risk, then clearly that should put upward pressure on spreads and lenders should be able to demand better terms. This could also force issuers to focus on deleveraging in order to improve their chances of reaccessing credit markets when it comes time to refinance."
And for institutional investors' portfolios, any tightening of spreads caused by lower supply means "some investors are bound to question the relative value of leveraged credit vs. competing asset classes," Mr. Aspbury added. "Some of them might even be compelled to move into higher risk or less liquid areas of the credit market," such as direct lending, in an effort to find higher yields.
However, he still expects leveraged loans to remain on institutional investors' agendas — even more so next year "as valuations improve and we move closer to the end of the Fed tightening cycle. In the meantime we have spoken to some clients who view investing in leveraged credit as a more palatable alternative to equities."
For 2019, leveraged finance issuance is expected to remain "robust" although below 2018 levels, said Peter Firth, London-based associate managing director at Moody's Investors Service.
There is another issue that could threaten leveraged finance next year. "Geopolitics are becoming increasingly unpredictable and investors' appetite for risk could turn if trade tensions intensify or political friction increases in some countries in the euro area, such as Italy, paving the way for unconventional policies. The likelihood of a no-deal Brexit has risen and would be negative for a variety of companies," Mr. Firth added.