A Guide to the Leveraged Loan Market: Evolution, Players and Risks

Foreword

Leveraged loans are on track to be the next subprime, imposing large losses on lenders and the economy and destabilizing the financial system. Understanding the players, the instruments and the history behind this highly-complex market is vital to limiting the risks.

A leveraged loan is a corporate loan that poses default risk similar to that of junk bonds.  Historically, leveraged loans posed relatively high default risks but had low loss-given-default – so portfolio losses were manageable, even in stressed periods. More recently, the nature of the risks has changed because of revisions in the language in the loan contracts. 

Each of the four articles in this series (summarized below) focuses on a different element of the leveraged loan market and its unique risks.

Introduction to Leveraged Loans

Leveraged loans differ from other corporate debt instruments. They are usually floating-rate, secured debt that can be refinanced with little or no penalty. Some are traded in broker-dealer markets, but liquidity tends to dry up when the market is stressed. Covenants written into the loan contracts provide important protections for lenders.

Protection Lite and Investor Risk in Leveraged Loans

Protection-lite loans are those with weakened covenants that limit the ability of borrowers to take actions, like moving collateral and assets out of lenders’ reach. The weakness is a very recent development and is in the form of complex additions to contract language that gives borrowers more flexibility. Investors and policymakers have paid little attention to this development.

Covenant Lite and Investor Risk in Leveraged Loans

In the past, loan contracts also contained covenants that gave power to lenders when borrowers showed evidence of distress, but such financial ratio covenants are now absent in many leveraged loans (also known as “covenant-lite” loans). Loss-given default on covenant lite loans may be worse than historical averages, but default rates may be better, so uncertainty remains about the net impact of covenant-lite on risk.

CLO and Mutual Fund Investor Risk from Leveraged Loans

The majority of leveraged loans are bought by collateralized loan obligations (CLOs) and loan mutual funds. CLOs are structured vehicles with tranched liabilities that bear losses in succession. Tranches that would be safe in episodes similar to the worst historical stress experience are vulnerable to losses on protection-lite loans. Loan mutual funds are vulnerable to the loss of loan market liquidity that accompanies market stress.