Leveraged Loans: A Threat to US Economic Health?

The leveraged loans* market in the US ballooned in 2018. According to the US Federal Reserve’s latest Financial Stability Report (May 2019), leveraged loans outstanding reached $1.15 trillion in the 4th quarter of 2018, a growth of 20.1 percent during 2018 alone. At the same time, deteriorating lending standards and investors’ growing risk appetite have increased funds available to indebted companies and created fresh vulnerability within the financial system.

Why should this market be of such concern if it is a shadow of the size of other markets, such as residential and equities? An economic slowdown could easily trigger defaults on leveraged debt and subsequent employment and investment contractions by borrowers that would exacerbate the downside risk to broader economic activity. Leveraged loans financially constrain employment and investment decisions of these already indebted borrowers, linking these core business decisions to debt availability, availability of which is in turn vulnerable to corporate debt spread and lending standards.

With leveraged debt growing so aggressively, the Fed may hold off on further interest rate hikes if it assesses the bottom could come out from the otherwise well-performing leveraged loans market. At present, the Fed's position is optimistic on the basis that it believes today's leveraged loan bundles are better structured than pre-crisis residential mortgage bundles. 

• While default rates may be relatively low - usually considered one sign of a strong economy - officials are already cautioning that this could change in the case of a slowdown.
• The US’ tense global trade relations with a number of major markets and the inverted yield curve will give the Reserve still more pause. At the end of May, the short term bond yield exceeded the long-term bond yield for the first time since 2007, suggesting market pessimism with regard to near-term economic conditions. 

*A leveraged loan issued by a commercial or investment bank is extended to a company with considerable preexisting debt and/or poor credit history. Because of the higher risk of default by a leveraged borrower, this type of debt tends to carry higher interest rates than general loans.