Corporate Debt Fears Are Well Overstated, Here's Why
As the 116th Congress reconvenes for its final session, members focused on our nation’s economy should take note that the $1.2 trillion leveraged loan market is showing none of the cracks that some policymakers predicted would appear in 2019. In fact, the often-maligned segment of the corporate debt market ended the year on strong footing with better-than-expected performance and a lower-than-predicted default rate.
The S&P/LSTA U.S. Leveraged Loan Index returned a very respectable 8.64% last year, with the 100 largest loans in the market outperforming the broader index with 10.65% gains. It’s equally notable that the loan default rate decreased from 1.63% to 1.39% on a year-over-year basis. As this occurred, market participants exhibited sustained discipline by walking away from lending opportunities that failed to meet their standards.
Policymakers must remember that leveraged loans, by design, present more credit risk than investment grade debt. But this doesn’t mean they’re analogous to the subprime mortgage loans that put the financial system at risk prior to the Great Recession.
The market has grown over the past decade for good reason: hundreds of non-investment grade companies, including iconic brands such as Burger King and Hilton Hotels, need capital to fuel operations, hiring, and expansion. In exchange for providing that capital, qualified lenders have been able to realize attractive returns in an otherwise low-yield environment. That growth has contributed to the flexibility, dynamism and rate of job growth in our economy
With all this in mind, it’s certainly prudent for our leaders in Washington, D.C. to closely monitor activity across lending markets. But with the benefit of looking through the rearview mirror that is 2019, we know that many of last year’s fears were grounded more in rhetoric than in reality, including:
Myth #1: The leveraged loan market poses systemic risk to the United States economy.
Multiple regulators, including current Federal Reserve Chairman Jerome Powell, have emphasized to Congress that the leveraged loan market is not systemically risky. Although normal-course credit risk certainly exists, levels remain manageable and continue to reflect institutional investors’ appetite for higher-yielding opportunities. Data also shows that non-investment grade borrowers' debt-servicing ability is still strong and there is no indication that a growing number of companies are strained, especially with interest rates at presently low levels.
Myth #2: There’s been a reckless surge in leveraged lending since the Great Recession.
The reality is that leveraged loans account for a small percentage – just 4% – of the domestic fixed income market. It’s equally critical to consider that the market has grown at a measured pace over the past decade, particularly in comparison to other types of corporate debt. While data from Wells Fargo Securities shows that the leveraged loan market has grown 107% since 2007, a March 2019 report from the Federal Reserve Bank of Dallas indicates that the BBB bond market has grown approximately 230% over a similar period. Leveraged loan market growth slowed to just 4% in 2019.
Myth #3: Collateralized loan obligations (CLOs) are akin to the derivatives that exacerbated our last financial crisis.
Unlike crisis-era collateralized debt obligations, CLOs are actively managed investment vehicles that play a very functional role in our capital markets by lending to corporate borrowers. They invest the majority of their capital in leveraged loans that are senior and secured. Although all of these loans bear risk, they typically hold the strongest claim on a borrower's assets in the event of a bankruptcy or default. It’s also notable that CLO managers fall under the jurisdiction of the Securities and Exchange Commission, like any other registered investment advisor.
Myth #4: A recession could devastate the leveraged loan market.
An economic downturn typically triggers an uptick in bankruptcies and debt restructurings, but it’s not as if loans that are senior and secured by collateral get wiped out in such a scenario. We must all keep in mind that the vast majority of non-investment grade companies are well-positioned to service their debts in the event of a recession. For companies that run businesses that are more correlated to the economy, there are options to help de-leverage or reengineer balance sheets amidst difficult times.
Policymakers in the post-crisis era are right to be hypersensitive to the risks of an economic downturn caused by reckless behavior. While I applaud their diligence, the leveraged loan market shouldn’t be deemed a likely catalyst for a next crisis. Coming to grips with the aforementioned realities can help ensure that capital formation and lending aren’t unnecessarily stifled.