Investor protection for loans to high-risk companies has never been lower, Moody’s says

Investors in the kinds of corporate debt that former Fed Chair Janet Yellen warned about a month ago have never been more exposed, according to Moody’s Investors Service.

Covenant quality, or the protections lenders get, reached an historic low in the third quarter of 2018, the most recent period for which data are available, according to an indicator the ratings agency uses. The reading sank to 4.16 on a scale that considers 1 the maximum protection and 5 the minimum.

“Lenders are exposed to greater risks than ever before,” Derek A. Gluckman, senior covenant officer at Moody’s, said in a research note with others. “Once again, our scores reflect weaker protections on a year-over-year basis in nearly every risk category we assess. Given the breadth and depth of covenant weakness, existing loans are in uncharted territory.”

Leveraged loans are given to companies that already have high levels of debt compared to capital and often have poor credit as well. So they’re already risky, and the lack of strict covenants makes then even more so.

During a December talk in New York City, Yellen compared the current leveraged loan situation to the risk behavior that helped cause the financial crisis. She said the debt is being bundled into packages called collateralized loan obligations that are then sold off to investors looking for yield.

“Corporate indebtedness is now quite high and I think it’s a danger that if there’s something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector,” the former central bank chief said.

Leveraged loans have gotten increasingly popular over the past few years, and their total volume outstanding of has now edged past the $1.2 trillion junk bond market, Moody’s reported.

The agency said that investors hungry for yield have been willing to tolerate looser protections to the point where they are now weaker than they were even before financial crisis exploded in 2008. Much of that money comes from the institutional side. Exchange-traded funds tracking the loan market hold more than $8 billion in assets, though the largest, the $5.3 billion Invesco Senior Loan fund, has seen about 30 percent of its assets redeemed over the past year.

“The breadth and depth of this weakness poses risks never before faced by leveraged loan investors, and outcomes under these extreme conditions have never been fully tested through a full market cycle,” Gluckman said.

Yellen isn’t the only one warning about the dangers.

Billionaire hedge fund manager Seth Klarman, of the Baupost Group, told clients in his latest investor letter that highly indebted companies will pose a significant danger should the economy weaken, which he expects to happen soon due in part to both government and corporate debt levels.

“Higher interest rates will significantly burden today’s highly leveraged issuers, and the challenges will be made more severe when the next economic downturn hits,” wrote the investor many consider to be inheriting Warren Buffett’s mantle as a market sage.

As far as specific threats from the lack of covenants, Moody’s mentions collateral control, guarantees and lien priority as the biggest issues. The agency said some lenders have taken advantage of weak protections to take even greater risks.