United States: Fed Concludes That Banks Have Improved Management Of Leveraged Lending Risks Even As Noninvestment-Grade Debt Has Grown

On May 6, 2019, the Board of Governors of the Federal Reserve System (the Board) published its annual Financial Stability Report. The Financial Stability Report presents the Federal Reserve Board’s current assessment of the resilience of the U S financial system and is similar to the reports published by other central banks and complements  the annual  report of the Financial  Stability Oversight Council.

The report highlights that the growth in business debt over the past 10 years has outpaced gross domestic product, pushing  nonfinancial business debt—measured as a share of business assets or, more broadly, as a share of gross domestic product—close to the highest levels experienced over the past 20 years, with the most rapid growth in debt over recent years concentrated among the riskiest firms. In the bond market, the Board notes that the ratings distribution of nonfinancial high-yield corporate bonds has been roughly stable over the past several years, with the share of high-yield bonds outstanding that are rated deep junk (B3/B- or below) declining slightly from its recent peak level of roughly 30% reached in 2016. In contrast, the distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50% of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion. Alongside the increase in the amount of non-investment grade debt, the Board notes that the  recent  Moody’s Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of leveraged loans with no financial maintenance covenants has risen substantially since the 2008 financial crisis. The Board cautions that a slowdown in economic activity could result in an increase in default rates, which would lead to elevated credit losses at financial institutions holding corporate debt, especially given the reduced amount of covenant protection on leveraged loans. Higher default rates and losses could also materialize through a sharp repricing of credit risk, which would lead to an increased debt service burden on firms with financing needs.

With respect to insurance companies, the largest investors in corporate bonds, the Board notes that downgrades of corporate bond holdings would lead to higher capital charges, which could prompt insurers to liquidate portions of their portfolios, potentially generating spillover losses to the broader market. Relatedly, a large increase in credit spreads would reduce the market value of those holdings. In addition to being large holders of corporate bonds, the Board notes, insurance firms have also increased their investments in collateralized loan obligation (CLO) tranches steadily since the 2008 financial crisis, in part because CLOs receive favorable capital treatment for insurance companies. Despite these potential vulnerabilities, the Board notes that insurance companies appear resilient, with regulatory capital ratios remaining high and leverage low.

With respect to banks, the Board notes that they appear well positioned to deal with the risks associated with underwriting leveraged loans and lending to nonbank financial intermediaries that invest in leveraged loans. The Board asserts that the financial soundness of the banking system has benefited from the annual “stress-tests,” which require that participating banks have sufficient capital to withstand material losses on these exposures and continue lending, as well as from the banks’ internal liquidity stress testing. With regard to leveraged lending specifically,  the Board notes that the banks have improved their management risks—reflecting, in part, the 2013 interagency guidance on leveraged lending—even as underwriting standards have deteriorated over the past decade. Moreover, large banks have improved their management of syndication pipelines.

With respect to the CLO market, the Board notes that investors in CLOs, which include insurance companies, banks, and other financial intermediaries, face the risk that strains within the underlying loan pool will result in unexpected losses on higher-rated tranches of the CLOs. The extent of these losses depends on the conservatism of the CLO structure— specifically, the amount of subordinate tranches and equity. Moreover, insufficient market liquidity for CLO tranches could amplify these risks. The secondary market is not very liquid even in normal times, and liquidity is likely to deteriorate in times of stress, which could amplify any price declines. The Board acknowledges that it is hard to know with certainty how today’s CLO structures and investors would fare in a prolonged period of stress. Although the average subordination level of triple-A-rated tranches moved up to 35% in 2018, underwriting standards for the underlying leveraged loans have deteriorated, as previously described. The Board notes, however, that compared with the investment vehicles associated with subprime mortgages in the financial crisis, CLOs are structured in a way that avoids run risk. In particular, they do not rely on funding that must be rolled over before the underlying assets mature, in contrast to other securitization vehicles such as asset-backed commercial paper. Moreover, the Board notes that the investor base for CLOs has become more stable than in the past. CLOs are now predominantly held by investors with relatively stable funding. In contrast, before the 2008 financial crisis, CLO tranches were commonly held by leveraged structured investment vehicles that relied heavily on short-term wholesale funding.

With respect to open-end mutual funds and exchange-traded funds that hold bank loans or high-yield bonds, the Board notes that these funds typically permit investors to redeem their shares daily, while the underlying assets can take substantially longer to sell. This mismatch suggests that investors may perceive some incentive to redeem their shares early if they think others are likely to try to do the same. Although widespread redemptions on mutual funds other than money market funds have not materialized during past episodes of stress, a sizable wave of such redemptions during a stress event could depress bond and loan prices, raising the cost of funds to businesses.

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