Moody’s Investors Services and S & P Global are rightly sounding the alarm, not only about the continued rise in leveraged lending and issuance of Collateralized Loan Obligations, but also about the deteriorating credit quality of both. According to the FDIC leveraged loans are typically unsecured, cashflow based loans. They are more than $5 million in size and account for more than 20% of the borrower’s debt.  Leveraged loans are usually made to borrowers with a ratio of senior debt to EBITDA of more than 3 times or total debt of more than 4 times.  Typically, the leveraged loan is utilized to finance a buyout, merger or acquisition, or a capital distribution or is a loan that has refinanced a prior loan originated for one of the aforementioned purposes.

Late last week, Moody’s released ‘From covenants to cushions: Top 10 credit challenges CLOs face today’ a report with stark warnings about expanding risks, especially arising “from growing weaknesses in the leveraged loan market, the loosening of transaction constraints and the changing regulatory and macroeconomic environments.”  Moody’s warnings are important, because CLO issuance in the U.S. has risen over 60% just since 2016. Significant issuance is not necessarily the problem when an economy is in growth mode as it has been in the last couple of years.  Yet, market signals and macroeconomic data are pointing to a a slowdown as early as next year.

CLO issuance has risen more than 60% in two years.S&P Global Market Intelligence’s LCD News

The worrisome issue here is that almost 85% of leveraged loans outstanding are covenant-lite. In an economic or market downturn, investors who end up holding these loans directly or through CLOs, will have little to protect them from significant losses.

[“source=forbes]