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Investors, driven by depressed interest rates, slower global economic growth and rich equity market valuations are examining non-traditional investment opportunities. The alternative asset management universe has grown significantly over the past few years, managing $8.8 trillion (tn) as at the end of 2017. Putting this in context, total world equity market capitalisation stood at $81tn on the same date. By March 2018, those managers held $2tn of this total in cash awaiting investment. While this is a large absolute amount, it is a slightly lower-than-average proportion of assets under management (Chart 1).
One common underlying feature of alternative investment strategies is leverage. Increasingly, investors have been investing in alternative credit funds, or making their own private lending deals. Corporate lending, particularly leveraged loan lending, has led current and former policymakers to draw attention to unhealthy lending practices that have become more common.
At a time when investors expect monetary policy and financial conditions to tighten, demand for floating rate, senior secured loans has led to more issuance. At the same time, credit quality is eroding as borrowers take advantage of indiscriminate lending. Debt levels have been steadily rising. Meanwhile, where leverage limits are in place, it’s becoming more common for lenders to take future potential earnings into account when calculating borrowing levels. Lending protections are also diluted, as most loans now have few (if any) covenants. In addition, there is anecdotal evidence of other protections weakening. This includes the opportunity to move collateral around, meaning that loans are not always backed by specific assets.
Recovery rates in corporate loans can vary significantly over time. They are currently in excess of 80%, but can be less than 50% in times of market stress. The recent weakening of covenants and documentation could mean that history fails to provide a good representation of future expectations. In a period of adverse market conditions, recovery rates could be low. Moody's forecasts that the average US first-lien (highest priority) senior secured term loan recovery rate will decline from the long-term average of 77% to 61% during the next recession. Industry exposure has also changed over time, from being a utility-led, asset-heavy market to one that is technology driven and asset light. The recovery rates on these companies are likely to be different. The default rate has been 3.1% on average, and is currently around 1.5%; this may also change going forward.
It is clear that tightening financial conditions will play a major role in the performance of loans.
Changes to earnings growth and interest rates will affect companies’ ability to cover the interest on these loans. Applying economic scenario analysis, such as our assumptions about a quantitative tightening-driven market tantrum or a rebound in trade growth, we can estimate how changing economic fundamentals affect the average loan over time. It is clear that tightening financial conditions will play a major role in the performance of loans. For those of lower credit quality, there may be significant stress, even under the less extreme scenarios.
It’s a reasonable assertion that quantitative tightening would have an effect on these markets. Liquidity has been plentiful and its removal is likely to affect leveraged loans directly and indirectly. It is possible that margin calls elsewhere will influence markets and lead investors to require liquidity in other parts of their portfolios.
Investors are now recognising the risks of this type of lending – credit spreads for new issuance have widened, and the secondary market has sold off. Despite recent spread widening, many loans were issued at very tight spreads over a prolonged period. Furthermore, a large proportion of those loans have been packaged into collateralised loan obligations, divided into tranches with credit ratings from AAA through to equity. Banks, as well as open and closed-ended funds, and insurance and pension funds hold the loans.
From a financial stability perspective there are issues to consider. The Financial Stability Board’s (FSB’s) Global Shadow Banking Monitoring Report highlighted situations where banks have had to withdraw from some types of lending due to regulation and other providers have been able to step in. Investors are providing shadow banking services in growing numbers and size. While these investors are providing capital to the economy, there may be a liquidity mismatch for others, which could cause systemic issues. In addition, the extent of investor reliance on bank funding is unclear.
More work is needed to fully understand the risks, as noted by the FSB in its report. The fact that global debt is at record highs underlines the importance of knowing the details of what this debt looks like, who owns it, and what the risks are. Following the global financial crisis, the FSB and the IMF jointly entered into the Data Gaps Initiative and, going into 2021, they plan to gather more data on the shadow banking sector.
In loans specifically, it seems sensible to monitor appetite for and acceptance of aggressively leveraged deals. It’s also important to consider an increasing ratio of downgrades to upgrades and a cash interest coverage ratio tending towards 1.5x. From a macroeconomic perspective, we are continuing to monitor gross domestic product growth, interest rate and inflation forecasts and, perhaps most importantly, financial conditions.