A $1.6 trillion credit market could batter the global economy. And it’s you that will take the hit if it implodes, not Wall Street.

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Leveraged loans make up an approximately $1.6 trillion market, and a variety of financial experts have raised concerns about the booming industry.
These loans are typically packaged into complex credit instruments which are then purchased by pension funds and mutual funds, among others.
The market has received criticism for the weak protections afforded to investors, with some fears that it could lead to major issues in the event of an economic downturn or recession.

Leveraged loans have caught a lot of heat in recent months.

These loans are, in simple terms, to riskier companies which have amassed a large amount of debt relative to their earnings. And the market for these loans has boomed.

Amid an extended period of low interest rates, 2017 saw a record amount of leveraged loan issuance, with 2018 following close behind, with over $700 billion in total issuance. The outstanding total of outstanding loans is estimated to be between $1.4 and 1.6 trillion.

A vast swathe of companies, including Space X, Uber, and Tesla, have taken advantage of beneficial lending conditions of late to pile up large amounts of debt which has often come with loose legal requirements, known as covenant-lite, which provide lenders with limited protections.

And as the market’s grown, the warnings have gotten louder. The Federal Reserve and the Bank of England have both expressed concern about the market, while the Financial Stability Board (FSB) said it will investigate the growing industry.

"The deterioration in underwriting standards for leveraged loans is increasingly worrisome," Ron Temple, cohead of multi-asset and head of US equity at Lazard Asset Management, said in an email to Business Insider.

The combination of increasing leverage and decreasing covenant protection "should be a warning sign to investors," he said. "As we assess the global credit landscape, this segment appears susceptible to disruption in the event of a downturn."

CLO, the next scary acronym?

These leveraged loans are often bundled up together with other similar loans and sold in the form of collateralized loan obligations (CLO). As the Bank of England’s financial policy committee has noted: "Leveraged loans are typically sold to non-bank investors (including to collateralised loan obligation funds), whose ability to sustain losses without materially impacting financing conditions is uncertain."

A recent comment piece in the New York Times by former banker William D. Cohan likened the repackaging of these loans to the debt instruments that helped trigger the financial crisis of 2008. He wrote:

"A decade ago, the high-yield investment du jour pushed by Wall Street was mortgage-backed securities — home mortgages that had been packaged up and sold as “safe” investments all over the world. Nowadays bankers and traders are pushing another form of supposedly “safe” investment, the “collateralized loan obligation,” or C.L.O."

Specifically, the concern is that:

Some of the companies that have taken on leveraged loans will not be able to manage the huge debt pile they’ve amassed, and corporate bankruptcies will begin to rise in a downturn.
85% of all leveraged loans are now "covenant-lite," in that they lack traditional requirements for companies to maintain certain financial benchmarks that protect the investors who pay for them, according to the Leveraged Data & Commentary unit of S&P Global Market Intelligence.
If corporate bankruptcies rise then weaker lender protections that go with "covenant-lite" deals will see the ultimate owners of the debt struggle to recover their investments, hurting returns.
Investors in CLOs will likely bear the brunt of corporate bankruptcies, according to Fed chairman Jerome Powell, while JPMorgan Chase CEO Jamie Dimon has said Wall Street banks aren’t that exposed to the market.
“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," Powell said late last year.
And Dimon has said the largest banks tend to invest in the safest part of the market, a category that accounts for about half of all outstanding leveraged loans.
So who are the investors in CLOs? Think hedge funds, mutual funds and pension funds. In other words, as Cohan writes, "you and me."

The market could continue to grow

The leveraged loan market is only a major issue in the event of companies running into economic difficulties. And the market could continue to grow for some time yet. Views on a potential US recession vary but generally signals point to a potential downturn at some point by 2020.

The other issue to consider is the broader economic context for the rise of leveraged loans. The limited appeal of US Treasuries and other government bonds has led to investors seeking better returns from other parts of the market. This seems unlikely to change given the Fed’s decision to not hike rates Wednesday and it indicating it would keep them static for the rest of 2019.

Recent figures indicate the leveraged loan market was hotting back up with February issuance standing at $61.2 billion, up 50% from January but some way down on the same month in 2018, according to Reuters LPC. CLO issuance stood at $13 billion according to LCD.

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Source: Business Insider – cburroughs@businessinsider.com (Callum Burroughs)