Those who follow the market are aware US 10-year bond yields have been rising steadily since July 2016.
But what many people don’t know is that there is a hidden debt bomb that could blow up in the next two years — leveraged loans.
A leveraged loan is a debt instrument made by lending syndicates to non-investment grade companies.
Usually pegged to the three month LIBOR, they are sometimes considered a safe-haven from the rising interest rates we have discussed.
But in some ways they are like the pay-day loans of the business world.
If you want to worry about something — this is it
As the head of JP Morgan’s US$100 billion alternatives investment arm notes the leveraged loan market consists of:
‘Private entities, that buy and sell private, direct lending and debt to each other. Unregulated, generally. It’s a shadow market. I would argue it’s a shadow banking market.’
He goes on to ominously say that:
‘If you want to worry about something in the next two or three years, this is it.’
Just like the sub-prime mortgage crisis of 2008 that set off the GFC, loosening of regulation is partly to blame.
The terms of the loans are set out in something called a covenant which stipulates what the borrower must do to preserve the interest of the loan.
This could include things like leverage ratios.
Leveraged loans put global recession on the cards
But increasingly, these covenants have been weakened to allow for more lending to take place.
More than 80% of new loans are now characterised as ‘covenant lite’.
This insidious debt bomb has now reached upwards of $1.36 billion in value.
As the Bank of England recently warned:
‘The global leveraged loan market was larger than — and was growing as quickly as — the US sub-prime mortgage market had been in 2006.’
And below we have a chart that maps out the risk of recession over different periods of time:
Things are starting to look pretty bad indeed.
It could be the leveraged loan market that sets it all off.
For Markets & Money