Let’s look at the stock market. To do that well, let’s freeze the stock market at its current level—over the past year, the S&P 500 has increased almost 30%. Can this just go on forever?
Living in that reality would be if we simply ignore anything that could upset the markets. In our reality, however, several things could go wrong—and once they do, it will have catastrophic consequences for the stock market.
Among these potential crisis-triggers are leverages loans. Also called “high-risk loans,” they are given to companies with poor credit history or companies with already considerable debt. Because these loans are considered to be at a higher risk of defaulting, their “price” is higher to compensate the lender for the added risk.
To track the risk level of leveraged loans, you must watch the level of the “loan covenants,” the conditions in the loan agreement that the borrower must fulfill and that protect the lender. Lighter covenants mean less conditions, which in turn means less protection for the lender. In other words, lighter covenants equal riskier loans. Currently, the market conditions allow borrowers to negotiate flexible covenants, thus exposing the lender to higher risk. With fewer protections in place, loans are more likely to default.
Moody’s Loan Covenant Quality Indicator (CQI) measures the degree of investor protection for leveraged loans. The CQI uses a scale of 1–5, where 1.0 is the highest possible investor protections and 5.0 the weakest. The CQI jumped to 4.47 in December 2019, hovering near the all-time record set earlier last year.
According to Satyajit Das, a former banker who was once hailed as one of the world’s 50 most influential financial figures, CLOs are faring no better and may become a financial bomb like the one that exploded a decade ago and triggered the Great Recession.
“Financial markets have short memories,” Das wrote in an opinion piece for Bloomberg. “[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.”
Look at the above graph while you keep the quotes below in mind.
CLOs are set up 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 subprime loans, and they led to the implosion of the housing bubble and the Great Recession.
CLO portfolios are diversified, so 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.”
Thus, we are in a 2008-like situation. Seeking higher returns, investors have increased their exposure, and the markets are characterized by a desire to escape from reality and by investors’ willful blindness.
But, once the economy worsens, we can quickly lose control, like we saw it in 2000 and 2008. When prices drop and credit availability withdraws, credit markets will stall. This will spread into the real economy and result in losses, sell-offs, and price drops. The fear will quickly invade the markets; consumers and investors will begin to question the financial position of our banks; and depositors will refuse to fund the banks.
Keep all of this in mind when you witness the euphoria about the stock markets’ record highs. You know how bad it can get. The next chart summarizes 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. Diversification simply means that a portion of your money should be out of the market and in tangible physical assets. Historically, precious metals are the most uncorrelated to stocks and bonds, providing one of the best forms of diversification around. You will be pleasantly surprised if you just saw how having a relatively small percentage of your investments in gold and silver helps to protect your portfolio when the market crashes.