Credit Suisse, one of the largest players in the $1.3tn market for leveraged loans, has issued an unusual defence of the product, after investors expressed concern over sliding standards and the IMF singled the type of loan out as a potential source of financial instability.
The Swiss investment bank’s asset management arm sent a confidential letter to its clients in September attempting to assuage fears over weakening investor protections in newly issued loans and the ballooning size of the market overall.
Leveraged loans have become one of the hottest areas of the credit markets, enabling private equity owners to load their companies up with debt and helping to fund a boom in merger and acquisition activity.
In the US alone, the outstanding value of leveraged loans has doubled in the past six years and stood at $1.1tn at the end of September, according to S&P Global Market Intelligence’s LCD. Adding in European loans, the market stands at $1.3tn.
Investors have poured money into the market because loans have floating interest rates and allow them to safeguard themselves from rising rates. The surge of investment has allowed companies to whittle away traditional investor protections, leaving creditors with fewer options should companies get into distress.
Asset managers such as AllianceBernstein and rating agencies including Moody’s have in recent weeks cautioned that investors may not fully understand the risks of leveraged loans, including the concern that less creditworthy companies have been able to secure financing.
Credit Suisse Asset Management’s letter to clients of its credit investments group is an acknowledgment of the mounting concern, but it argued the fears were overdone.
“The Credit Suisse Asset Management Credit Investments Group (‘CIG’) would like to reiterate the compelling potential benefits of the institutional leveraged loan market in terms of achieving attractive risk-adjusted returns,” read the letter, which was reviewed by the Financial Times.
“In addition, there are significant differences between the pre-crisis loan market and today’s market in terms of growth rate, ownership, and overall credit profile.”
Credit Suisse is one of the most significant players in the leveraged loan market. Its asset management arm offers investors exposure to loans through a string of lucrative products, including investment funds and as the third-largest US manager of so-called collateralised loan obligations, which issue bonds backed by pools of loans. The division’s credit investments group manages $46.5bn in loan strategies across the US and Europe.
Credit Suisse’s investment bank also ranked among the top three arrangers of US loans for private equity-backed deals in 2018, trailing only JPMorgan and Bank of America, according to Dealogic.
The IMF expressed its concerns about the loan market in its global financial stability report in April. “Signs of late credit cycle dynamics are already emerging in the leveraged loan market and, in some cases, are reminiscent of past episodes of investor excesses,” it warned.
While regulators had curbed banks’ exposure to risky loans, the Fund said, activity had shifted toward institutional investors through products such as CLOs, bank loan mutual funds, private equity firms and other private funds.
Analysts have focused criticism on the erosion of covenants in loan documentation designed to govern a company’s finances. Weaknesses in investor protections can often allow companies to issue dividends or become increasingly indebted. Other protections have also been impaired or removed from some loans, such as an investor’s claim on an asset in default or the privileged status of certain lenders to be paid first.
“There is a real degradation in the quality of loan agreements,” said Christina Padgett, an analyst at Moody’s. “That is investors’ primary concern.”
In its letter, which was not signed by any individual executive, Credit Suisse Asset Management pushed back. While acknowledging the growth of loans with looser covenants, it said, “leveraged loans still have a variety of covenants and other investor protections”. It also noted that the companies borrowing through the loan market were “highly diversified”.
The asset management unit laid some of the blame for recent concerns on what it characterised as a “wave” of private equity-backed activity in the loan market.
It added that predictions for loan defaults remained below long-term averages and that one of the largest buyers of the securities were CLOs, vehicles that “do not become forced sellers and actually provide consistent, stabilising demand for loans”. The growth in the size of the leveraged loan market has also slowed from the years before the crisis and was “hardly an indication of excess”, it wrote.
It noted that riskier loans with more aggressive terms were often rebuffed by investors, reflected in poor trading of the securities. “We believe that fundamental credit selection is more important than ever for portfolio management and active management will be a key driver of performance,” it said.
Credit Suisse declined to comment on the letter.
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