The investment now giving central bankers the jitters
Risks are building in the financial system and there are consequences for those who stick their head in the sand, whether by loading up on debt or offering loans to risky borrowers
Here on the Value Perspective, we are by no means alone in believing risk is building up across the financial system – the snag is spotting precisely where.
After all, the thing about asset bubbles is that, almost by definition, they are unspottable.
They quietly inflate while everybody’s attention is focused elsewhere – even if that attention is often on the perceived rewards, rather than the potential risks, of the very same investment.
Thus, when everybody is agreed a particular risk is going to bring everything crashing down … well, of course it could be that, but it will probably be something else.
Consider, for example, the $1.3 trillion (£1.01 trillion) market for ‘leveraged loans’ – so-called, as this International Monetary Fund (IMF) blog explains, because “the ratio of the borrower’s debt to assets or earnings significantly exceeds industry norms”.
In a line that would not look out of place on The Value Perspective, the piece’s authors write: “With interest rates extremely low for years and with ample money flowing though the financial system, yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun.”
The blog goes on to note the way “speculative-grade companies have been eager to load up on cheap debt” and that, globally, new issuance of leveraged loans hit a record $788bn in 2017, surpassing the pre-financial crisis high of $762bn in 2007.
This year also looks set to run that close – it is on course to hit some $745bn, with the majority of borrowers being energy, healthcare, technology and telecommunications businesses.
“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 piece continues. “If this market froze, what would be the economic impact? In a worst-cast scenario, could a breakdown threaten financial stability?”
All good questions and, in posing them, the IMF bloggers join a long list of financial experts to have sounded warnings about the leveraged loan sector over the last couple of months, including former US Federal Reserve chair Janet Yellen and officials from the Bank of England, the Reserve Bank of Australia and the ‘central bankers’ central bank’, the Bank for International Settlements (BIS).
To be clear, it is not the growth of the leveraged loan market in itself that is the major worry here.
Of much greater concern is the way the issuers of these loans are becoming ever more leveraged while – in an echo of other articles on The Value Perspective on the subject of mandatory convertible bonds, say, or covenant-lite bonds – the protections or ‘covenants’ being offered to, or indeed expected by, the lenders is deteriorating.
As this Financial Times article notes, “given these weakening standards”, Moody’s rates 37% of leveraged loans as ‘B3’ or lower, which it says is the lowest rating typically acceptable to investors.
Moody's also tracks various metrics to gauge covenant quality and scores the average strength on a scale of 1 to 5, with 5 being bad. According to this FT Alphaville piece, the indicator has reached 4.12 – the weakest level on record.
The article continues: “Making matters worse, many of these leveraged loans are being packaged into collateralised loan obligations to be bought and sold by investors. Mutual funds have become major buyers of these instruments, and when the unwind comes – as is all but certain – here’s how the BIS thinks it could play out:
“‘Mark-to-market losses could spur fund redemptions, induce fire sales and further depress prices. These dynamics may affect not only investors holding these loans, but also the broader economy by blocking the flow of funds to the leveraged credit market.’” Referencing those central banker warnings mentioned above, the article concludes: “Per the Fed, that most definitely sounds like a risk to financial stability.”
Bleak picture painted
If that were not alarming enough, this Financial Times piece paints an even bleaker picture, noting Obama-era regulations had at least prevented businesses from ratcheting up debt further.
Yet private equity groups have now “taken advantage of the Trump administration’s more relaxed approach by doubling the proportion of deals done with leverage of seven times or greater, which had often been barred under the old rules”.
Furthermore – in what is now a familiar refrain – lenders have become less exacting on what actually constitutes ‘profits’.
As the FT explains, it is now routine to include clauses allowing companies to inflate their earnings numbers “by ‘adjusting’ current-year profits to include the expected fruits of future cost savings or growth plans. Yet the cash benefits of such initiatives may take years to materialise – if they arrive at all.”
Will markets collapse?
So is the leveraged loan market set to be the next Ground Zero for a meltdown in financial markets?
Clearly some very informed people are growing very worried but, as we said at the start, while it is not impossible, that tends not to be how these things work.
Not that we are making any forecasts either way because, as we never tire of pointing out, here on The Value Perspective, the future is unforecastable.
What we would say, however, is that every time we see these instances of businesses taking on more debt, say, or investors accepting far fewer protections in the hope of eking out a few more basis points of yield, we are reminded of economist Hyman Minsky’s hypothesis on financial instability – that all stable economies sow the seeds of their own instability.
Or to put it another way: everything feels fine right up until it doesn’t.
When the IMF, the BIS and the world’s central bankers warn in unison about a particular market risk, it would be foolish to carry on as if everything is fine.
Risks are building in the financial system and there are consequences for those who stick their head in the sand, whether by loading up on debt or offering loans to risky borrowers.
When markets quake, debt only ever serves to amplify the aftershocks.
Investment Specialist, Equity Value
I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm.
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