Market Insights

Will Leveraged Loans Blow Up the Market?

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If we could freeze the S&P 500 at its current level for the rest of 2019, we’d be looking at double-digit returns!

(Source: Macrotrends)

If reality worked like that—we’d be able to just ignore anything that would be a risk to the market. Instead, we must face the fact that several things could go wrong before the end of the year, and when they do, the effect on a frothy stock market will be devastating. One of the things that could go wrong is leveraged loans.

What are Leveraged Loans?

What are leveraged loans (also called “high-risk loans”)? These are loans that are extended to individuals or companies who have a poor credit history, or who already have considerable debt. Because lenders consider these loans to have a higher risk of default, the loans are more costly for the borrower. This means the lender receives a higher return as compensation for the added risk. Leveraged loans can be packaged as security and sold to investors, which is called collateralized loan obligations (CLOs).

Currently, these high-risk leveraged loans are growing at a fast pace. There is $1.46 trillion outstanding in leveraged loans and $700 billion in CLOs—numbers that have gotten the attention of not only the media and politicians but also rating agencies.

To track the level of risks there are in leveraged loans, what you need to watch is the level of the “loan covenants” required to get the loan. The loan covenants are the conditions in the loan agreement that the borrower must fulfill, which protects the lender. The lighter these covenants are, the fewer conditions the borrower must meet, which means less protection for the lender, thus a riskier loan.

Current market conditions allow borrowers to negotiate flexible covenant provisions, which leave the lenders exposed to higher risk.

Moody’s Loan Covenant Quality Indicator

Moody’s Loan Covenant Quality Indicator measures the degree of overall investor protection for leveraged loans. The indicator rose to a record of 4.16 in the first quarter of 2019, breaking the previous record of 4.10 from 2018. The indicator uses a 1–5 scale where 1.0 shows the highest possible investor protections and 5.0 the weakest. With fewer protections in place, loans are more likely to default

In terms of the packaged CLOs, the situation is not any better. According to Satyajit Das, a former banker who was once hailed as one of the world’s 50 most influential financial figures, CLOs may become a financial bomb like the one that exploded a decade ago.

“Financial markets have short memories,” Das wrote in an opinion piece for Bloomberg. “Of late, they’ve convinced themselves that collateralized loan obligations are much safer instruments than the collateralized debt obligations, or CDOs, on which they’re based and which helped precipitate the 2008 crisis. They’re wrong—and dangerously so.”

Both CLOs and CDOs package multiple loans to create artificial bond-like investments. CLOs are structured to be a safer way to increase the leverage of a debt portfolio, and they are used mostly to repackage corporate loans and extremely risky consumer credit, such as car loans. CDOs repackage mortgages and subprimes and led to the subprime meltdown and the Great Recession.

Because CLO portfolios are diversified, investors assume they are safer. But, says Das, “relative to mortgages, corporate-loan portfolios typically are made up of fewer and larger loans, which increases concentration risk. Leveraged loans are highly sensitive to economic conditions, and defaults may be correlated, with many loans experiencing problems simultaneously.”

This all mounts up to a 2008-like situation. In search of higher returns, investors have increased their exposure, and the markets are plagued by a euphoric escape from reality and by investors’ willful blindness.

Once economic conditions worsen, things can quickly spiral out of control as we saw with the dot-com bubble and the housing bubble. Falling prices and tightening credit availability will cause credit markets to stall. This will spread into the real economy, causing losses, sell-offs, and price drops. Fear will spread across the markets, consumers and investors will start to question the financial position of banks, and depositors will refuse to fund banks. So, before you get excited about the S&P 500 performance in 2019, you can see how bad it can get in the next chart, which shows how each growing bubble led to a worse crash of the S&P 500.

The only way to protect yourself against risks in the stock and bond markets, like CLOs, is to diversify into non-paper assets. Historically, precious metals are the most uncorrelated to stocks and bonds, providing one of the best forms of diversification around.

I’ve spent my career preparing for this exact scenario, and my friends, my family, and my clients are all in on investment portfolios that will thrive when the paper-asset markets spiral out of control. Would you like to get more information about protecting and growing your wealth? Then, I will gladly discuss it with you—with no obligations—if you have a few minutes to do so.

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More About Fred

With over 14 years in the financial industry, Fred is using his expertise to help Gold Alliance’s clients protect their investments with gold and other precious metals. During his career, Fred has focused on commodities and precious metals as investment assets. He has published several articles on the commodities markets, investing in precious metals for retirement accounts, and other topics. He has been with Gold Alliance for over 2 years as a leading Sr. Portfolio Manager.