“We often see more demand for loans from investors and borrowers in the latter half of the business cycle,” said John Fraser, head of credit management at Investcorp, which has multiple funds managing over $5 billion in the U.S. loan market. It manages another $6 billion in the smaller European market. “With good but not explosive growth in the economy and the Fed raising rates, it’s the perfect environment for the loan market.”
Retail investors like the idea of floating rates and more security than high-yield bonds. More than $11 billion has flowed into the 64 bank loan mutual funds so far this year, according to data from Morningstar. Total assets in the funds now top $144 billion.
At the end of 2017, there was more than $1.36 trillion in outstanding loans, according to Moody’s research, making the loan market now slightly bigger than the high-yield bond market.
While the strong investor demand has helped leveraged loans post a roughly 2 percent return so far this year compared to a flat total return for high-yield bonds, the terms of the loans have deteriorated dramatically in the last several years. Many market analysts expect that investors in loans made today could face major losses if and when the economy turns and borrowers default on the loans.
“We’ve seen this in the past,” said Fraser. “Whenever the market is strong, terms become more borrower-friendly. “Credit risks will grow in the future. In this environment we tend to say no to aggressive terms,” he added.
It appears everyone else is saying “yes” to those terms. Leveraged loans, unregulated by the Securities & Exchange Commission, are governed by covenants that stipulate what provisions — if any — borrowers must follow to preserve the interests of lenders. Usually they involve maintaining interest coverage and leverage ratios, as well as preserving the position of lenders in the company’s capital structure.
One of the chief selling points of leveraged loans has been their seniority to bond- and stockholders and their call on corporate assets in the event of default. First-lien, however, is not what it used to be and protection for lenders is at an all-time low in the market.
“We have never seen weaker loan covenants,” said Derek Gluckman, senior covenant officer for Moody’s Investor Services, which provides credit ratings for leveraged loans. That includes prior to the financial crisis. “As demand continues to be strong, the loan terms keep softening.”
Moody’s now characterizes more than 80 percent of new loans in the market as so-called “covenant lite” loans. They have no financial maintenance restrictions and they give borrowers lots of flexibility to issue more debt, pay out dividends to shareholders and even pull collateral out from under lenders. “Covenant lite is just the tip of the iceberg,” said Gluckman. “All the provisions are weaker now across all categories.”