Watchdog warns of dangers in riskier corner of debt market

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Dollar sign cracked floor, Financial crisis © yodiyim /123RF Stock PhotosIn a low-rate world where income is increasingly tough to find, more and more investors are getting into the riskier corners of lending to companies.

A financial watchdog says that might cause problems in financial markets during a downturn.

The Financial Stability Board, an international group created to co-ordinate financial regulators, released a report Thursday on the leveraged loan market, which includes loans used by private-equity firms and others to pay for leveraged buyouts, mergers, debt refinancing and other activities.

These leveraged loans often go to companies that are already encumbered by large piles of debt and have bad credit ratings. In return, they can carry relatively high interest rates that float up or down, which is attractive to investors when rates are rising. These loans can also be packaged into investments called collateralized loan obligations, or CLOs.

The FSB said several factors suggest vulnerabilities have grown in the leveraged loan and CLO markets. Not only are borrowers taking on more debt, but investors may not be fully appreciating weaker protections built into the loans. More non-banks are also entering the markets, such as investment funds, insurance companies and pension funds.

“As a result, these markets may be more vulnerable to macroeconomic shocks than in the past, and stress in leveraged loan markets could disrupt other markets,” the FSB wrote in its report.

CLO issuance came to a nearly complete halt after the financial crisis in 2009 and 2010, but boomed in ensuing years as investors scrounged for income. By 2014, CLO issuance returned to levels seen before the financial crisis and has remained strong since. The leveraged loan market globally was as big as $1.4 trillion to $3.2 trillion, according to estimates as of December 2018.

Some watchdogs and investors have recently been warning about the fast growth in leveraged loans and in corporate debt broadly. They say the buildup in debt likely won’t trigger a recession by itself, but it could accelerate any downturn.

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