February 13, 2019 - Earlier this week, the FT hosted a “point-counterpoint” debate on whether “leveraged loans pose a threat to the US economy”. At the LSTA, we found this conversation stimulating. However, we felt a major point – around what systemic risk actually means – might have been missed. As a result, we offered up a comment to the FT, which we publish in full below.
We found the debate on whether “leveraged loans pose a risk to the US economy” very interesting. Unfortunately, many people appear to conflate the concept of “credit risk” with the concept of “systemic risk”. Credit risk, which we define as the possibility of losing money due to individual corporate defaults, does exist in the loan market. But similar risks exist in nearly every market, including investment grade bonds, high yield bonds and equity markets. For instance, could an investor lose money by buying Apple stock? Absolutely. Is that a systemic risk? Unlikely.
Likewise, we do not think leveraged loans pose a systemic risk (by which we mean the risk that performance of a single asset class (here leveraged lending) may have on the broader U.S. economy). First, outstanding “institutional” term loans (to which this debate refers) total $1.2 trillion dollars. That is just 4% of the overall fixed income market. In contrast, Apple and Amazon alone have a combined market capitalization of roughly $1.6 trillion.
Second, the vast amount of the $1.2 trillion outstanding loans resides in the hands of stable investors that would not be forced to sell them even if prices dropped. The biggest loan investors are “open market” CLOs, which are not analogues of CDOs. A recent post by the LSTA reviews research explaining the differences between CDOs and CLOs. These include a stable ratings history, consistent underwriting standards, consistent asset class norms, structuring simplicity, a prohibition on investments in derivatives, real money buyers and asset diversity. The stability of CLOs has led to remarkable performance: Of the 10,000 CLO notes that S&P rated from 1994 to mid-2018, exactly 38 defaulted. That is a 0.38% cumulative 25-year default rate. Not even investment grade bonds come anywhere close to such a stellar track record. This is not a “risk to the US economy”.