The Daily Update - Leverage Lending

The Bank of International Settlements (BIS), widely known as the central bank for central banks, in its latest report warns about high-risk lending. They are ringing the alarm bells not just about the total amount of debt but the fact investors appear less and less concerned about protecting themselves against losses.

According to the BIS the total of leveraged loans and high yield bonds outstanding in the US and Europe has doubled to $2.65 trillion since the financial crisis and while high yield accounts for more than half of the amount, leverage loans now account for around 45%.

The BIS is concerned regarding the trend to covenant-light lending where investors are waiving protection in the search for higher yields. Moody’s Investor Services in a recent review point out that 80% of newly issued loans are now covenant-light and their index which measures covenant strength is at an all-time high indicating weaker borrower protection.

The trend has been exasperated by the continued fall in default rates which is forecast to reach the 2% level by year end from the 2.8% level seen just last month, according to Moody’s. Broadly, the huge amount of liquidity in the system has encouraged lenders to lend at very high leverage values which some observers are warning ‘opens up the sector to a negative shock’.

The BIS report suggests that the prospect of ‘fire sales’ by leveraged mutual funds is indeed a real risk should ratings downgrades pick up putting bank balance sheets at risk. As a Finance Professor from the University of Chicago points out, ‘The borrowing they do is usually from a bank; they buy a loan from a bank and borrow money from a bank to buy the loan, so the risk would ultimately get back to the banks’ balance sheet’, ‘maybe not today or tomorrow, but there is a growing risk’.

We prefer the old adage, ‘only lend to those that can pay you back’ and risking your capital for a few extra basis points just does not equate on our risk/reward scale.

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