Bank regulators recently sounded alarms about weak commercial loan underwriting standards that could come back to haunt lenders if the economy suffers a new downturn. The credit ratings firm Moody's also warned of rising risks in corporate lending.
There are certainly reasons to worry about risk in the corporate loan market. Loans to sub-investment-grade companies are set to have their heartiest year ever, eclipsing the $535 billion record set in 2007. In addition, borrower-friendly debt is on the rise. Bonds with payment-in-kind provisions that give borrowers the option to "pay" by issuing more debt (PIK toggles), and loans that lack traditional early-warning signal financial ratios (covenant-lite loans), are both on the upswing. Bonds with PIK toggles are at their highest level since the financial crisis at $10 billion, and covenant-lite loans exploded in 2013 to their highest level ever, reaching a new height of $188 billion in September.
Despite this undeniable froth, commercial loan markets remain level-headed. Bond deals with PIK toggles have more conservative terms than those prior to the financial crisis. As noted by Matthew Fuller in Forbes, firms that are now issuing PIK toggle bonds have significantly lower leverage than in 2007-2008. Borrowers are also limited in their ability to pay-in-kind by leverage and debt service coverage ratios, and the bonds are shorter-term as well.
Covenant-lite loans are also being conservatively dolled out by banks. Reporting on an October loan market conference, Reuters' Leela Parker Deo noted that covenant-lite loans are only going to companies with "rock solid" credit histories, which usually only includes companies that have $50 million or more in earnings. Collateralized loan obligations, who are significant nonbank loan investors, have also not increased the limits on their ability to purchase covenant-lite loans.
So while investors and regulators would be wise to keep an eye on the risks being taken in loan markets, sounding an alarm right now seems premature. Although regulators seem to have the view that annual default risk in loans is in the low double-digits, one loan investor estimates annual default risk as being close to 2%.
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