The power of Collateralized Loan Obligations.
“The global leveraged loan market is larger than – and growing as quickly as – the US subprime mortgage market was in 2006,” said the Bank of England’s Financial Policy Committee in the statement from its latest meeting. And the committee is “concerned by the rapid growth of leveraged lending.”
In terms of magnitude, the US and EU “leveraged loan” market combined now exceeds $1.3 trillion, up from $50 billion at the turn of the century.
A “leveraged loan” is a loan that is extended to junk-rated (BB+ or lower), over-indebted companies. These loans are considered too risky for banks to keep on their books. Instead, banks sell them to loan funds, or they package them into highly rated Collateralized Loan Obligations (CLOs) and sell them to CLO funds and other institutional investors. In the UK, over £38 billion ($50 billion) of these loans were issued in 2017 — more double the amount in 2016 — and a further £30 billion ($39 billion) has already been issued in 2018.
Leveraged loans are popular among investors because of the slightly higher interest rates they offer, and because they’re often based on floating rates, a positive in an environment where interest rates are rising. Investors earn a set amount of interest — the so-called margin — on top of the prevailing Libor benchmark rate. As the Libor rises, so too does the interest. The loans’ floating interest rates offer investors some degree of protection from rising rates, until, of course, the borrower defaults.
While banks benefit from issuing leveraged loans via hefty fees for arrangement, structuring and portfolio management, since these loans are typically sliced, diced and sold in global financial markets in classic sub-prime fashion. Among the biggest buyers are CLO funds…