The market for junk-rated corporate loans may be setting itself up for greater losses than in past cycles, because companies will struggle to refinance debt cheaply as interest rates rise from record lows, according to Martin Pfinsgraff, the Office of the Comptroller of the Currency’s top large-bank supervisor.
“It is likely that there will be a higher level of default and debt restructuring,” Pfinsgraff, senior deputy comptroller for large-bank supervision, said in an e-mailed response to questions from Bloomberg News. “Because of the rapid increase in the volume of leveraged issuance the past three years, the magnitude of potential losses under a stress scenario may likely increase from the prior cycles.”
Loans rated below investment-grade are at the center of one of the most important tests since the worldwide financial crisis of whether tools used by bank regulators can temper risk taking. So far, supervisory pressure has had only a moderate impact on the reach-for-yield caused by the Fed’s aggressive monetary policy, analysts said.
A sixth year of near-zero interest rates from the Federal Reserve is fueling demand for high-yield debt, with banks already arranging $337 billion of U.S. leveraged loans sold to institutional investors in 2014, according to data compiled by Bloomberg. That’s on top of a record $695 billion in 2013.
About half of the loans this year are covenant-light, meaning they lack standard lender protections such as financial maintenance requirements, following an unprecedented $315 billion last year, the data show. Leveraged, or junk, loans are rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.
“The data speak for themselves,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc. in Washington, which consults for some of the world’s largest banks on financial regulation. “The market is not only vibrant, but so covenant-light as to ratify policy worries about yield chasing.”
The OCC, the Fed and the Federal Deposit Insurance Corp. updated guidance last year on leveraged lending, noting “tremendous growth” in the volume of credits “the participation of unregulated investors,” and the use of “aggressive” capital structures. Regulators have been increasing pressure on banks since then to boost their underwriting standards.
Pfinsgraff said that in previous periods of economic stress borrowing costs fell, allowing highly indebted issuers to refinance at lower interest rates.
“Because the existing high volume of leveraged loans has been underwritten at record-low rates, there will be little opportunity to refinance should economic stress arise,” Pfinsgraff said.
Leveraged loan prices plummeted to 59.2 cents on the dollar December 2008, three months after the collapse of Lehman Brothers Holdings Inc. deepened the worst recession since the Great Depression. The high-yield, high-risk debt rose to 99.1 cents on July 1, the highest since July 2007, according to the S&P/LSTA U.S. Leveraged Loan 100 Index.
Covenant-light issuers now default more than their peers, according to Moody’s. Companies that obtained covenant-light loans between 2005 and the first quarter of 2014 showed an average three-year default rate of 18.8 percent, compared with 13.4 percent for all junk-rated borrowers in the U.S., Moody’s said in a June 24 report.
“We are concerned with compliance and reputation risks among the institutions we supervise as well as the significant litigation risk banks may face if they fail to effectively originate or underwrite products they sell,” Pfinsgraff said.
Junk-rated borrowers have $737 billion of debt due in the next five years, peaking in 2018 with the most maturities since just after the financial crisis, Moody’s said in a Feb. 4 report.
The regulators’ guidance was unusually prescriptive in its underwriting standards section, noting that leverage levels in excess of six times total debt to a measure of earnings “raises concern for most industries.”
Unlike rules, supervisory guidance isn’t binding although it serves as a red flag for examiners in routine oversight. Even with the guidance in place, Pfinsgraff said OCC examiners have “noted erosion” in three areas.
Debt levels as a multiple of a measure of earnings “continue to increase, which raises the risk of default under stress,” he said. Loan principal amortization remains low, increasing dependence on refinancing at maturity, and “maintenance and even now incurrence covenants are scant, which limit the lender’s ability to protect their interests should credit deterioration occur,” he said in the e-mail.
The Fed’s monetary policy is driving the reach for yield in the financial system. The central bank has kept its benchmark lending rate near zero since 2008 as the economy remained far from policy makers’ goals of stable prices and full employment. The Fed has also suppressed borrowing costs by buying mortgage-backed securities and Treasuries, expanding its balance sheet to a record $4.38 trillion in the process.
Fed Chair Janet Yellen said in a press conference last month that trends in the leverage loan and high-yield bond markets “have certainly caught our attention.”
“We are using supervisory tools and regulations both to make the financial system more robust and to pay particular attention to areas where we’ve spotted concerns, like leveraged lending, which is very much a focus of our supervision,” she said.