Morgan Stanley warns that this corner of the credit market may be the first to collapse as interest rates rise

Morgan Stanley warns that this corner of the credit market may be the first to collapse as interest rates rise

Now that Fed Chair Jerome Powell has made it very clear that the Fed has no plans to slow the pace of interest rate hikes, some bond market experts are warning that even the most speculative areas of the credit market may be rude. the awakening.

Team at Morgan Stanley MS,
He warned that leveraged loans could be a “canary in the credit coal mine” due to floating interest rates and the growing weakness in the creditworthiness of issuers. With the US economy slowing, these borrowers can expect to suffer a double whammy as cash flows deteriorate as debt servicing costs rise.

For those unfamiliar with this corner of the credit market, “leverage loans” usually refer to highly secured bank loans offered to borrowers with credit ratings below investment grade, according to the Wells Fargo Investment Institute.

We see: Is the junk bond market too bullish with a soft landing?

Typically, these loans are purchased by institutions such as investment banks, which then pool the loans and regroup them into CLOs, which are then sold to investors.

The era of low interest rates that followed the Great Financial Crisis of 2008 swelled the leveraged loan market. According to data cited by Srikanth Sankaran of Morgan Stanley, it has nearly doubled in size since 2015 to $1.4 trillion in loans maturing through the end of June. Much of this issuance was exploited by private equity firms to fund corporate buyouts, or simply to refinance.

With loan balances ballooning, the quality of borrowers deteriorated, and that wasn’t much of a problem when benchmark interest rates were close to 0%. But with interest rates rising, investors should keep an eye on this space, because the quality of borrowers is much lower than in the junk bond market. While nearly half of junk bond borrowers have credit ratings near the top of the non-investment grade pile, a quarter of leveraged loan borrowers have a “BB” rating. The rest is less.

Source: Morgan Stanley

Morgan Stanley is certainly not the only bank urging customers to tread with caution. A team of analysts from Wells Fargo WFC,
The Investment Institute said in a research note on Tuesday that investors should treat leveraged loans with caution.

However, they added, the explosion is not a foregone conclusion, and Wells maintains a “neutral” view of the space.

One reason is that only 9% of outstanding LL loans will mature between now and the end of next year.

Source: Wells Fargo

As interest rates rise, the demand for new leveraged loans has fallen. Since the beginning of the year, the value of loans issued by borrowers in the United States has been less than $200 billion, down about 57% from the same period last year, according to a team of credit analysts at Bank of America BAC,

This makes sense given the sharp decline in mergers and acquisitions.

With interest rates expected to rise, investors looking for warning signs should expect a wave of cuts, according to Morgan Stanley Sankaran. But it remains to be seen if the price shock turns out to be something bigger.

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