For the first time in history, the U.S. leveraged finance market, a combination of leveraged loans and high yield (below investment grade) bonds, is over $3 trillion. Leveraged loans have grown almost 130% since the financial crisis, more than twice the rate of gross domestic product which increased 57% in the same time period. High yield bond issuance also grew significantly, over 90%. These levels of leveraged finance growth far surpass the growth of regular corporate bonds and loan issuance.
A growing economy since the financial crisis and a very low interest rate environment have encouraged investors to chase yield; in turn, this demand for riskier assets has enabled indebted American companies to become even more leveraged.
Below investment grade is the overwhelming largest part of the leveraged loan market, especially B-. 84% of leveraged loans are covenant lite. Moreover, loan documentation protection continues to deteriorate. According to data in the recent ‘Fitch U.S. Leveraged Finance Market Insight Report,’ loan documents are offering creditors some of the lowest protection since Fitch started tracking this documentation on October 2016. Combined with lite covenants, creditors will not have a lot of protection if borrowers default.
Fortunately, at present probability of default of many leveraged loan borrowers and high yield bond issuers has declined from last year. The current twelve-month trailing default rate for leveraged loans is about 1.5%, a significant decline from its recent peak level in October 2020 of 4.5%. Energy, retail, and leisure and entertainment have the highest expected probability of default of all sectors and significantly above the 1.5% for all leveraged loans.
Bank regulators, investors and rating agencies should keep a good watch on the enormous rise in leveraged finance markets and decreasing protections for creditors and bond investors. It is too easy to get lulled by the recent decline in defaults. A worsening of the COVD pandemic or any unexpected operational risk challenge, such as a cyber security attack or a natural disaster, could quickly leave creditors and investors very unprotected.
Note: Rodríguez Valladares has published over 40 articles on leveraged finance markets, corporate debt, and collateralized loan obligations. They may be found here.