"This Will End Poorly," JPM Says About Obscure Credit Bubble

(Marketwatch) Much hand-wringing has accompanied the resurgence of one corner of the credit market on Wall Street, which has displayed many of the hallmarks of a bubble.

However, Anton Pil, managing partner at J.P. Morgan Asset Management, may have put it best at a Wednesday luncheon the firm hosted to discuss its guide to alternative investments.

“This will end poorly,” Pil said, expressing his view that growing appetite for so-called leveraged loans and a recent surge in production of a form of that debt that has increasingly carried fewer protections for investors and restrictions for borrowers — known as covenant lite — could blossom into a bigger problem on Wall Street.

David Lebovitz, global market strategist at the firm, citing recent its research, said the composition of lenders in private credit has shifted away from traditional banks and toward nonbank lenders, and as a result, the quality of leveraged loans has deteriorated.

Back in 1994, 71% of so-called leveraged loans were funded by bank lenders and 29% were provided by nonbanks. Now, 91% of leveraged loans are provided by nonbank lenders, Lebovitz explained.

As a result, “nearly 80% of leveraged loans issued last year were considered covenant lite,” Lebovitz said at the luncheon, which also featured Pil and David Kelly, J.P. Morgan Asset Management’s chief global strategist.

In late January, Moody’s Investors Service said its Loan Covenant Quality Indicator, which gauges the degree of overall investor protection in covenant packages of speculative-grade-loans, rose to a record 4.16 in the quarter, topping the previous high of 4.10 hit in the third quarter of 2018 and again in the second quarter of 2018.

Leveraged loans are typically used to finance private-equity transactions and mergers and acquisitions, as well as to refinance or recapitalize existing debt on a company’s balance sheet.

Because that debt carries floating interest rates, a rising interest-rate environment like the one that was in play in 2018, can make servicing that type of debt more expensive for borrowers, making them more prone to defaults. Moreover, an economy in the latter stages of expansion, where the expectations for a recession are growing, also creates an unsteady backdrop for risky credit, the J.P. Morgan asset managers said.

Leveraged-loan borrowing in the U.S. has ballooned over the past two years, surging beyond levels seen during the 2007-2009 financial crisis. Such borrowing hit a record in 2017 at $1.66 trillion and was at $1.46 trillion in 2018, according to Dealogic data. That represents the biggest two-year rise ever in the industry.

Private credit has been attractive to institutional investors like pension funds because they aren’t prone to vicious price swings like in stocks, and they can offer richer yields than corporate bonds or Treasurys, with U.S. 10-year government bonds offering a relatively paltry yield of 2.69%. By comparison, the average dividend yield for components of the Dow Jones Industrial Average is 2.4% and 2.1% for the S&P 500 index according to FactSet data, but those benchmarks also have soared about 10% so far in 2019.

Both the International Monetary Fund, in a blog post, and the Federal Reserve have recently flagged the re-emergence of leveraged loans as a risk worth closely watching.

Despite worries surrounding leveraged loans, Lebovitz sounded comparatively more sanguine than Pil on the potential for such debt to produce a systemic failure for financial markets akin to the implosion produced in the aftermath of the mortgage-backed securities debacle that rippled across the globe a decade ago.

“In our view, a wave of defaults would absolutely exacerbate any downturn in the economy because bank exposure is modest, we don’t think it poses the same systemic risk as mortgages did back in 2008,” he said.

That said, Lebovitz noted that a cycle of nonbank lenders pushing private loans was driving up multiples on deals, according to data from the Bank of England.

“They estimate that last year leveraged-loan issuance was about $800 billion dollars globally and of that $800 billion about 60% of that leveraged-loan issuance was used to finance M&A [mergers] and LBO [leveraged buyouts] transactions. So right, you have private credit funds that are now lending to private-equity firms,” he said.

“The increasing amount of leverage in the system, generally, is pushing up the multiples you’re seeing on these deals,” Lebovitz said.

So, rather than freak out, Lebovitz said investors need to be discerning about the debt they invest in and the managers they choose.


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