FAQ: Understanding the Rising Systemic Risks in the US Leveraged Loan Market

What are leveraged loans?

Leveraged loans are extended to companies with significant existing debt or less robust credit histories, making them inherently riskier, with lenders compensated by higher interest rates.

Why is the US leveraged loan market considered at risk?

The market is at risk due to underpriced loans, the prominent role of less-regulated non-bank lenders, deteriorating loan standards, and a surge in default rates, reaching a four-year high of 7.2% in December 2024.

What role do non-bank lenders play in the leveraged loan market?

Non-bank lenders, or ‘shadow lenders,’ operate with less regulatory oversight than traditional banks, leading to concerns about unchecked risk-taking and a lack of transparency in the leveraged loan market.

What are Collateralized Loan Obligations (CLOs) and how do they affect the market?

CLOs package leveraged loans into securities sold to investors, transferring risk away from original lenders but creating complex, opaque structures where investors may lack clear information about the underlying assets.

What are ‘covenant-lite’ loans and why are they concerning?

‘Covenant-lite’ loans have fewer protective clauses for lenders, giving borrowers more flexibility even when their financial health deteriorates, making it harder for lenders to mitigate losses in distress.

How have default rates on US leveraged loans changed recently?

Default rates on US leveraged loans surged to a four-year high of 7.2% in December 2024, with many borrowers resorting to ‘distressed exchanges’ to avoid outright bankruptcy.

What are the implications of the current state of the leveraged loan market?

The current state, marked by underpriced risk, unregulated shadow banking, and relaxed lending standards, poses a systemic threat to financial stability, potentially leading to another financial crisis.

What actions have regulators taken regarding the leveraged loan market?

Regulators have expressed heightened concern over the rapid growth and increasing interconnections within the private credit market, which includes non-bank lenders and their leveraged loan activities, due to its potential systemic threat.