- An obscure and often overlooked Fed survey is flashing a warning about the growing leveraged loan market.
- The Federal Reserve’s Senior Loan Officer Opinion Survey, which takes responses from 70 domestic US banks, showed that lending standards for commercial and industrial (C&I) loans eased in the third quarter.
- Demand for commercial and industrial loans also fell, the survey said.
- Several major institutions, including the Fed itself, and the Bank of England, have warned about the rise of leveraged loans.
This year’s rumbling debt story looks like it isn’t going anywhere – despite numerous warnings from major figures in the world of finance – especially if banks continue to lend without adequate protections in the booming leveraged loan market.
According to the Federal Reserve’s Senior Loan Officer Opinion Survey, which takes responses from 70 domestic US banks, lending standards and terms for commercial and industrial (C&I) loans eased in the third quarter of this year.
The figures apply to both large and mid-market companies suggesting that so-called “covenant lite” lending is permeating much of the US credit market.
Covenant-lite loans often lack lender protections that are built into traditional loan contracts, potentially allowing companies to take on more debt or loosen restrictions on dividend payments.
Global leveraged loan volumes, which have increasingly featured less stringent covenants, recently hit a total volume of $1.6 trillion, according to the Institute of International Finance.
Banks surveyed by the Fed also cited increased competition from other lenders as an important reason for banks’ easing their standards or terms. Increased tolerance for risk is also thought to be behind banks’ decision to reduce covenant quality on loans. The Federal Reserve, the Bank of England, and the Reserve Bank of Australia have all previously sounded the alarm on the decreasing quality of leveraged lending.
The data also suggests that loan demand is falling citing increases in customers internally generated funds, reduced investment, and customers shifting their borrowing to new lenders as reasons for the slowdown.
According to the Fed’s survey: “[Banks are] reportedly narrowing loan rate spreads on C&I loans to firms of all sizes. A significant net fraction of banks also reportedly eased loan covenants to large and middle-market firms.”
The picture is different for foreign banks, however, which reported that demand for C&I loans remained unchanged over the third quarter.
While reduced covenant quality is often associated with higher credit supply within debt markets putting borrowers in a position of strength. However, highly leveraged corporates who are able to continue piling on debt are at the centre of a worrying trend in the world of credit which looks set to continue.