The Loan Engine
Regulators are looking at whether to buy loan funds in the next crisis.
By: Greg Obenshain
The Federal Reserve Bank of New York is out with a staff report warning of the dangers in leveraged loan funds. Their report finds that loans are more susceptible to a run risk than bonds due to illiquidity of the investments and the procyclicality of the asset class.
The Federal Reserve warns that these loans could be a risk to financial stability. “Disruptions in the loan-fund segment could easily propagate to the rest of the corporate debt mutual fund sector,” they warn. “[F]low dislocations in loan funds may trigger fire sale dynamics … and amplify the initial shock.”
The focus on leveraged loans comes after the rapid growth of the asset class over the past decade. The leveraged loan segment of the credit market has grown at a 7.4% annualized rate since 2009 versus high yield bonds at 5.8%.
Figure 1: Leveraged Loans Volumes Have Grown Faster Than High Yield
Source: S&P Global
Our research suggests that much of this lending is, in fact, riskier than high-yield bond lending, despite being senior secured. A rule to remember in lending is that the best borrowers borrow long, fixed, and unsecured. The worst borrowers borrow short, floating rate, and secured. And in this case, the main driver of leveraged loan growth is private equity using loans to fund buyouts. Senior secured leveraged loans help private equity firms maximize the amount of leverage for the lowest cost.
As a result, leveraged loan funds are of lower quality than high-yield funds. The below graph shows the breakdown by rating of the two largest loan ETFs, Blackstone Senior Loan ETF (SRLN, $9.8 billion) and Invesco’s Senior Loan ETF (BKLN, $5.0 billion), compared to the largest high-yield ETF, iShares’ (HYG, $15.9 billion).
Figure 2: Loan Funds Have Lower Ratings Than Bond Funds
Sources: Fund web sites, Bloomberg, and Verdad Analysis. Uses Moody’s ratings for both funds.
It may be surprising to many people that, while 50% of the bond ETF is rated Ba or better, 60% of the loan funds are rated B or below. These are issue ratings which are meant to be an estimate of relative expected loss. For senior secured loans, the agencies often notch ratings up from the corporate rating, while for unsecured bonds they notch them down. So the loan ETFs are in fact invested in instruments with a higher risk of loss, according to the rating agencies. Perhaps they are wrong, but this would not be in the direction (too lenient) that most critics of past agency performance would expect. As we argued in “In Defense of Ratings Agencies,” the rating agencies rely on long histories of default to create their models for expected loss, and investors would be wise to start with an assumption that the rating agencies’ assessments are likely to prove correct.
Low ratings, illiquidity, and opaque structures make this a problematic asset class. The New York Fed notes that loan funds are much more pro-cyclical than bond funds due not just to higher illiquidity but also to the reinforcing nature of policy rate moves. Rate rises in healthy environments increase loan returns (but are often dampened by loan renegotiations as noted by the New York Fed), while rate decreases in difficult times decrease prospective returns for loan holders at the worst possible moment. To these issues we would add the higher credit risk of levered buyouts, which are more likely to default in bad times. We explored the problems with the riskiest portions of the loan market in more detail in our essay on private credit.
As a result, there is a real risk that in a future crisis the leveraged loan market could freeze up, grinding one of the most significant credit-creation engines in the US economy to a halt. This has the staff of the Federal Reserve Bank of New York worried. The second paragraph of the staff report reads, “We find empirical evidence suggesting that loan funds, which are key credit providers in the leveraged lending market, are much more vulnerable to run risk than any other category of debt mutual funds. Building on the institutional features of their asset holdings, we further document the role of monetary policy as a coordinating factor driving loan funds’ investor flows and their volatility, suggesting a novel channel of monetary policy transmission.”
It is not hard to imagine that, in the next crisis, regulators may step in and buy leveraged loan ETFs much like they bought investment-grade ETFs and some high-yield ETFs in March of 2020.