A record third of U.S. loans sold to investors this year came from companies that have borrowed more than recommended by financial watchdogs, raising concerns that companies’ growing reliance on credit could exacerbate an economic downturn.
At the end of November, 33% of the 954 leveraged loans issued in the United States in 2021 to date had a debt-to-earnings ratio greater than six times, according to LCD data dating back to 2005. These loans have exceeded a threshold set by the federal government. Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation in 2013 which was adopted by the banking industry as a loose cap on leveraged loans.
The six-fold threshold is not a hard line and the guidelines – unlike a more formal rule – are not binding. Nonetheless, the guidelines say that “generally” debt greater than six times earnings before interest, taxes, depreciation and amortization “is a concern for most industries.”
“There is incredible leverage in the system,” said Dennis Kelleher, president of advocacy group Better Markets. “It created a time bomb.”
The fear is that if US economic growth weakens or lending rates rise, significant debt could become unmanageable, accelerating the decline of heavily indebted companies and potentially spilling over into the economy. The data is also based on numbers that allow for “add-ons” that increase EBITDA and reduce calculated leverage, meaning that the amount of leverage in some transactions could be significantly higher.
Kelleher said the historic Fed intervention last year to ease financial conditions in the aftermath of the pandemic fueled a wave of corporate borrowing, aided by an influx of liquidity into the financial system that made lower lending market standards.
Bankers acknowledge that some transactions have become aggressive, but say the driving force behind the rise in leverage was not the result of poor underwriting but the changing nature of the companies borrowing in this market. For example, high growth tech companies may have negative cash flow as they expand, but high income and enterprise value to support the debt incurred.
The IT and electronics sector of leveraged loans is now the largest with more than 20% of the market, against a little over 13% when the guidelines were drafted in 2013. The services and leasing sector, also considered to have high recurring income, also increased significantly.
Bankers stressed that the guidelines say that companies’ ability to repay 50% of total debt over seven years “provides evidence of adequate repayment capacity” even if their leverage is more than six times.
Global debt has increased this year to an average of 5.2 times the debt to EBITDA, to return to the peak reached before the pandemic.
Along with rising valuations, private equity firms are also putting up larger checks to buy businesses, with that money lying under loan investors in bankruptcy. Bankers and investors have also pointed to the low cost of interest payments over the past decade, lowering the cost for companies to carry higher debt.
S&P Global analysts said the current threat to debt markets was benign, with economic growth and accommodative monetary policy supporting riskier companies. The defaults should remain low for now.
Still, Ramki Muthukrishnan, head of leveraged finance at S&P, said there was cause for concern in the longer term.
“Obviously, the fact that these companies are heavily indebted means that the business conditions have to be extremely favorable for them to be able to repay their debts or refinance themselves in the future,” he said.
Not covered – Markets, finance and strong opinion
Robert Armstrong dissects the most important market trends and explains how the best minds on Wall Street are reacting to them. Sign up here to receive the newsletter straight to your inbox every day of the week