The leveraged loan market has grown 100% in a decade; a significant amount are covenant-lite. About 50% of the loans are held in collateralized loan obligations, which do have some similarities to collateralized debt obligations. In a downturn, leveraged loans and CLOs could amplify a crisis.
” for the latest BIS Quarterly, there are similarities between the “CLO market today and the CDO market then, including some that could give rise to financial distress. These include the deteriorating credit quality of CLOs’ underlying assets; the opacity of indirect exposures; the high concentration of banks’ direct holdings; and the uncertain resilience of senior tranches, which depend crucially on the correlation of losses among underlying loans.
My concern is that with two recent cuts in interest rates by the Federal Reserve, coupled with very low and even negative rates in both advanced and emerging markets, this environment will lead to more borrowing from leveraged borrowers and issuance of CLOs. This will likely happen because there is appetite from investors for higher yielding assets in order to make up for the very low interest rate environment.
Already, retail investors are possibly signaling a return to the leveraged loan markets . According to LCD News “after 43 weeks and nearly $27 billion of withdrawals, retain investors tip-toe back into the U.S. leveraged loan market, [into ETFs], a $24 million for the week ended on September 18.”While we have reasonably good public data about how much banks and insurance companies are holding in leveraged loans and CLOs, the rest is everyone’s guess.
and insurance companies which have to increase capital to sustain unexpected losses when assets become riskier or more illiquid. Increasing capital in an economic downturn is not easy, so companies typically have to sell assets, which can lead to fire sales. Importantly, before an economic downturn comes, civil servants, nurses, firemen, teachers and policemen whose pensions have exposures to leveraged loans and CLOs will also take a hit as well.
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