A record one-third of US loans sold to investors this year came from companies that borrowed more than financial watchdogs recommend, raising concerns over rising reliance on corporate credit that could exacerbate an economic downturn.
By the end of November, 33 per cent of the 954 US leveraged loans issued in 2021 so far had a ratio of debt to earnings that exceeded six times, according to LCD data going back to 2005. These loans breached a threshold set by the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation in 2013 that was adopted by the banking industry as a loose cap on leveraged lending.
The six times threshold is not a hard line, and the guidance — unlike a more formal rule — is not enforceable. Nonetheless, the guidance states that “generally”, debt in excess of six times earnings before interest, taxes, depreciation and amortisation “raises concerns for most industries”.
“There is an insane amount of leverage in the system,” said Dennis Kelleher, president of the advocacy group Better Markets. “It has created a ticking time bomb.”
The fear is that if US economic growth weakens, or borrowing rates rip higher, large debt loads could become unmanageable, accelerating the decline of heavily indebted companies and potentially rippling through the economy. The data is also based on figures that allow for “add-backs” that increase Ebitda and lower the calculated leverage, meaning the amount of leverage in some deals could be markedly higher.
Kelleher said the historic intervention by the Fed last year to ease financial conditions in the wake of the pandemic had fuelled a wave of corporate borrowing, facilitated by a flood of cash into the financial system that has driven standards in the loan market lower.
Bankers acknowledge that some deals have become aggressive, but say the driving force of the rise in leverage was not the result of poor underwriting but of the changing nature of the companies that borrow in this market. For example, high-growth technology companies may have negative cash flow as they expand but high revenue and enterprise value to support the debt being taken on.
The computer and electronics sector of leveraged loans is now the largest at more than 20 per cent of the market, up from just above 13 per cent when the guidance was written in 2013. The services and leasing sector, also seen as having high recurring revenue, has also grown significantly.
Bankers pointed to where the guidance says that the ability for companies to repay 50 per cent of total debt over seven years “provides evidence of adequate repayment capacity”, even if they are leveraged above six times.
Overall leverage has risen this year to an average of 5.2 times debt to Ebitda, back to the peak reached before the pandemic.
Alongside rising valuations, private equity firms are also putting up larger cheques to buy companies, with that money sitting beneath loan investors in the event of a bankruptcy. Bankers and investors also pointed to the low cost of interest payments over the past decade reducing the cost to companies of supporting higher debt loads.
Analysts at S&P Global said the current threat to debt markets was benign, with economic growth and accommodative monetary policy supporting riskier companies. Defaults are expected to remain low for now.
Nonetheless, Ramki Muthukrishnan, head of leveraged finance at S&P, said there was cause for concern over a longer time horizon.
“Clearly the fact these companies are highly leveraged means that business conditions need to be extremely favourable for them to pay down debt or refinance in the future,” he said.
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