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Risky corporate debt is piling up, out of sight from global regulators

Companies around the world have racked up an immense amount of debt. One worry is that these borrowers could default on some part of the $3 trillion in risky borrowing, setting off a wave of losses for banks and investors. The other worry is that officials aren’t sure who exactly owns a sizable swath of this debt.

Regulators in the US and Europe have been sounding the alarm about leveraged loans—a loose term that refers to junk bonds and loans that have a higher risk of default. Companies sometimes gorge on this type of debt to acquire other companies. Private equity firms also use billions of dollars of debt to take over public companies and, ideally, spruce them up and make more competitive.

Financial engineering can also play a part. About a quarter of these risky loans are held by collateralized loan obligations (CLO), according to the Financial Stability Board (FSB). These types of vehicles resemble the ones that bought up subprime mortgages before the 2008 credit crisis, but they hold corporate debt instead of home mortgages.

You can think of CLOs as a kind investment fund. They raise money by issuing bonds and investing the proceeds in junk loans. Some of the bonds they issue get paid first and are senior to the other ones that are riskier and won’t get paid if the underlying loans default. The riskier the bonds are, the more they yield.

Once again, there’s not a lot of data on who is investing in CLOs. These vehicles hold about $744 billion of risky debt, and watchdogs don’t know who holds some 14% of the securities issued by them.

Banks are the biggest holders of leveraged loans, with more than 40% of the market on their balance sheets, according to FSB data. In some ways, that’s a good thing. These institutions were at the epicenter of the last financial crisis, and they’ve been fortified with capital to help them withstand defaults. They undergo intense testing by regulators to make sure they are sound. Officials have a pretty good idea what’s going on inside banks and how much risk they’re taking.

“Although banks’ exposures to leveraged loans and CLOs are sizable, their risk management and measurement practices have improved since the financial crisis, and their capital and liquidity positions have been strengthened,” the FSB said in a report last month.

It’s a reasonable bet that the next panic won’t start within the banking system. Instead, experts think it will take place somewhere in the financial shadows, where there’s less transparency.

Investment funds and insurance companies are the next-largest holders of high-risk corporate debt, according to FSB data; combined with banks, these three groups account for about 80% of leveraged loans.

The bigger concern could be what the FSB calls “certain other non-bank financial intermediaries.” Regulators aren’t sure exactly who they are, but these parties likely include pensions, hedge funds, sovereign wealth funds, and private debt investors. These entities likely hold the riskiest portions of the debt, although officials admit “this has not been confirmed with data.”

This matters for everyone because heavily indebted companies are more vulnerable when the economy stumbles: “Such corporates are likely to reduce investment and employment, which could further exacerbate an economic downturn,” the FSB said.

How did we get here?
It seems a little crazy to be talking about financial engineering and risky debt just a little over 10 years since the last credit crisis featured both prominently. In part, this is because of central banks. The US Federal Reserve and European Central Bank have taken unprecedented steps to reduce interest rates, forcing investors, from hedge funds in London to retirees in Iowa, to take ever more risk to get an adequate return.

There are finally signs in some economies that prospects for middle-class workers, hard hit by the last economic plunge, are getting brighter. Policymakers in Washington and Brussels have been wary of doing anything that could cool the economy when a tighter labor market is putting more money in many workers’ pockets.

Ten-year US government bonds yield less than 2%, while the equivalent German yields are negative. Around $15 trillion of bonds have negative yields, according to the IMF. Investors have resorted to taking on ever more risk, which has enabled a lot of questionable behavior.

In the leveraged loan market, that behavior includes a buyout spree which could culminate with the biggest buyout in history: private equity firm KKR could find a way to take pharmacy chain Walgreens Boots Alliance private, according to Bloomberg. The deal could be funded with more than $50 billion of junk debt.

Some private equity firms have also been heaping debt on their portfolio companies and rewarding themselves with dividends, instead of investing in these businesses, according to Moody’s Investors Service. With markets awash in money, investors are lending money while getting weaker protections, known as covenants, in return.

The global economy doesn’t have to suffer significantly for these loans to become a problem. A slowdown half as severe as the 2008 collapse could put some $19 trillion of debt at risk, meaning companies’ earnings aren’t sufficient to cover their interest expenses, according to the IMF. That’s 40% of the world’s corporate debt in major economies.

The IMF has a few suggestions on how to deal with the glut of risky bonds and loans. Right now some tax codes incentivize companies load up on debt, for example. Revised tax policies might slow this debt binge. Another key suggestion is increased transparency about the non-bank owners of leveraged loans, where regulators are often in the dark.
Source: Quartz

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