A recent study from the University of Bath has raised alarms about the growing systemic risks in the US leveraged loan market, warning of potential repercussions that could mirror the conditions leading up to past financial crises. The study identifies several concerning trends, including the underpricing of highly leveraged loans, the increasing dominance of less-regulated non-bank lenders, and a notable decline in loan standards.
Leveraged loans, which are extended to companies with high levels of debt or weaker credit histories, are becoming increasingly underpriced, especially by non-bank lenders. These lenders, operating with minimal regulatory oversight, are contributing to a market where risk is not adequately compensated. The default rates on these loans have already reached a four-year high of 7.2% in December 2024, with many borrowers engaging in 'distressed exchanges' to avoid bankruptcy, further highlighting the market's fragility.
The study points to several key factors exacerbating the risks: the weakening pricing of leverage risk since 2014, the significant role of non-bank 'shadow lenders', the surge in Collateralized Loan Obligation (CLO) issuance, and the widespread adoption of 'covenant-lite' loans that offer fewer protections for lenders. With approximately 70% of the US leveraged loan market now comprised of CLOs, the complexity and opacity of these financial instruments pose additional challenges to market stability.
Regulators have begun to express concerns over the rapid growth and interconnectedness of the private credit market, which is largely fueled by non-bank lenders and their leveraged loan activities. The absence of a comprehensive federal regulatory framework for these lenders raises questions about the potential for unchecked risk-taking and the lack of transparency in the market. The study underscores the urgent need for regulatory attention to mitigate the systemic risks posed by the current trends in the leveraged loan market.
