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Concern is growing about the leverage loan market and the amount of debt owned by US investors. So what is a leveraged loan? It's a loan to a risky company, typically one that's already in debt or has a poor credit history. Banks lend money to these companies and then sell the loans on to investors, such as pension funds and asset managers.
But why have investors been buying these loans? The interest rate paid by borrowers rises and falls in line with other short-term interest rates, rather than being fixed like a bond. Loans also get priority over bonds in bankruptcy, theoretically making them a safer way to lend to lower quality companies. This has been particularly attractive in recent years because the Federal Reserve, which sets US monetary policy, has been increasing interest rates. In turn, investors have funnelled money toward the loan market, seeking to benefit from rising rates.
At over $1tn the loan market is now larger than the high-yield bond market. But this demand has given companies the upper hand, allowing them to borrow cash on more and more favourable terms and tear up many of the protections investors once had when extending credit. This reduction in lending standards and soaring growth in the market has caught the eye of central banks and financial watchdogs. The Federal Reserve, International Monetary Fund, and the Bank for International Settlements are among a host of policymakers to recently warn of the systemic risk leverage lending could pose to the financial sector.
But many investors are less concerned, at least, less concerned that this could spark the next financial crisis. In part, that's because the risks sit with private investors, rather than the big, interconnected banks. And despite appearances, investors often say they are confident companies will be able to repay their debts.
Nonetheless, some cracks have emerged in recent months, as heightened market volatility stemming from rising uncertainty about the global economic outlook has seen investors pull money out of this riskier asset class. In other words, a downturn in the US economy could spell the end of the Fed raising rates, reducing the allure of leveraged loans. Curiously, if things do turn sour, it may take longer for companies to default on their debt because they are not bound by such strict standards. But if they do eventually fail, investors are likely to recover less than they otherwise would have if those same protections had been in place, raising the possibility that the worst is yet to come.
