On April 10, 2019, the International Monetary Fund (IMF) held a press conference to discuss its semiannual Global Financial Stability Report (the GFSR), which assesses key risks facing the global financial system. The GFSR highlights policies that may mitigate systemic risks, thereby contributing to global financial stability and sustained economic growth of IMF members.
The IMF stated that lending to highly leveraged corporate borrowers is an area of particular concern. The GFSR notes that looser underwriting standards, decreased investor protection, a higher share of weak credits and reduced subordination increase the likelihood of distress and reduce recovery rates in the event of a sudden tightening in financial conditions or a sharp downturn. The GFSR further notes that greater participation of investment funds in the leveraged loan market means that a flood of investor redemptions could lead to additional market stress. The GFSR also notes, however, that the potential spillovers from distress in the leveraged loan market to the rest of the financial system are mitigated by a number of factors, including:
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Banks play a smaller role in the leveraged loan market. Loans originated and retained on banks’ balance sheets account for only 2.5% of total tangible bank equity. Warehouse lines to collateralized loan obligation managers remain modest, estimated at about $20 billion currently versus more than $200 billion in 2008. Pipeline risk management has improved, and overall levels are generally less than one-third of the peak levels before the 2008 financial crisis.
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Collateralized loan obligations are held mainly by nonbank investors. Global banks hold about 33% (or $250 billion) of the total stock of collateralized loan obligations but are estimated to hold mostly the highest-rated tranches. The default risk on higher-rated tranches has been low based on recent history, and increased credit enhancements could further reduce defaults.
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Foreign bank demand for collateralized loan obligations remains strong. Estimates suggest that Japanese banks account for a sizable share of demand for highly rated tranches. Current U.S. and EU AAA collateralized loan obligation yields, hedged into yen, have continued to provide an attractive return compared with domestic bonds.
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Demand from investment funds is sizable, but there are few crossover investors. Concentration of fund ownership is meaningful, with estimates that the top five and top 20 U.S. loan products own nearly 15% and 30%, respectively, of the U.S. loan market. However, it is expected that spillovers to other fixed-income markets will be contained because some of the largest crossover credit funds have only marginal exposure to leveraged loans.
The GFSR concludes that large-scale redemptions from investment funds could induce fire sales that depress prices, affecting the institutional investors holding these loans as well as the broader economy, by blocking the flow of funds to the leveraged credit market. In this event, economic activity of borrowers representing a wide range of sectors could be jeopardized because a sizable 31% of issuance is used for refinancing. The borrowers’ ability to swiftly shift to the high-yield bond market could be hampered by the relatively large size of the leveraged loan market. Further financial stability implications will ultimately depend on whether nonbanks have retained material links to banks that could amplify the impact of market disruptions on the broader financial system.
The full text of the GFSR can be found here.
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