The Federal Reserve has identified rising sales of risky corporate debt as a growing risk to the US financial system.
In its latest biannual Financial Stability Report, the Fed again cited potential risks tied to non-financial corporate borrowing. It singled out loans to companies with high levels of outstanding debt, aka leveraged loans—a $1.1 trillion market that increased by 20% in 2018 amid declining credit standards, as well as elevated asset prices and historically high debt owned by US businesses
The share of new, large loans going to comparatively risky borrowers now exceeds peak levels reached in 2007 and 2014 and while default levels remain low, the Fed warns of a potential risk if US economic growth loses momentum.
A repeated warning
In its latest report, the Fed repeats its warning that risks associated with leveraged loans have “intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt.
“Any weakening of economic activity could boost default rates and lead to credit-related contractions to employment and investment among these businesses.”
The central bank had already warned in its November 2018 report that leverage loan standards were deteriorating, and Federal Reserve Bank of Dallas president, Robert Kaplan, wrote earlier this year that corporate debt could “amplify” any slowdown in United States growth and become a burden in the next downturn.
The increase in leveraged lending partly reflects the continuing strength of the US economy and relatively low interest rates on safer assets that have encouraged some investors to hold riskier debt with more attractive returns.
However, the Fed offers a degree of assurance that rising levels of risky corporate debt present a different risk to the mortgage-backed security boom that helped fuel the 2008 financial crisis.
It says the collateralised loan obligations (CLOs) are structured in a more secure way than their housing-backed relatives, and banks are better positioned to handle their exposure to corporate debt, although the report concludes: “It is hard to know with certainty how today’s CLO structures and investors would fare in a prolonged period of stress”.
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