The $1.3 trillion market for loans to companies with junk-rated credit is nearing a danger point, the International Monetary Fund has warned.
Loan-underwriting standards have deteriorated, even as new issuance has climbed to record levels, IMF officials wrote Thursday in a post on the organization's website.
Demand for the loans, which tend to come with higher interest rates, has been stoked by the past decade of ultra-low interest rates, after central banks in the U.S., Europe and Japan moved to ease monetary conditions following the 2008 financial crisis. Although the Federal Reserve has been raising U.S. rates since late 2015, investors are still clamoring for the high-yielding investments.
Earlier this year, Fitch Ratings noted that the market for junk-rated loans had surpassed the historically bigger market for bonds with sub-investment-grade ratings.
"With interest rates extremely low for years and with ample money flowing though the financial system, yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun," the IMF officials wrote.
The IMF's alarm comes as a growing chorus of credit-rating analysts and lawmakers warn that an economic downturn could lead to an increase in debt defaults in the growing market.
U.S. Senator Elizabeth Warren, a Massachusetts Democrat who sits on the legislative chamber's banking committee, wrote Wednesday in a letter to regulators including Fed Chairman Jerome Powell that she was concerned about the growing risks in the leveraged-loan market. Regulators are not taking significant enough actions to prevent growing risks to the financial system, she wrote.
"I fear that continued growth in leveraged lending, along with the steady degradation in loan terms, creates significant risk to the financial system and the American economy," Warren wrote. She cited a warning in October by the Bank of England that the market bears hallmarks of the subprime mortgage market in the years prior to the financial crisis of 2008.
Companies often use leveraged loans to finance mergers and acquisitions, allowing them to increase revenue but at the cost of higher interest payments that must be supported by the additional business.
Many leveraged loans are bought by mutual funds, investment banks or other investors who package them into bonds called "collateralized loan obligations," or CLOs -- similar to the subprime-mortgage-backed securities that were at the heart of the 2008 financial crisis.
According to analysts at Bank of America, underwriting quality has declined as the market accelerated, partly due to the increasing prevalence of "covenant-lite" loans that give fewer protections to lenders or the investors who buy them. Some 80% of loans now are considered "covenant lite," up from 10% in 2010, according to Bank of America.
Meanwhile, more loans are going to small, first-time borrowers whose credit quality is untested, and credit ratings are decreasing, even within the spectrum of the already subinvestment-grade junk category, according to the analysts.
"A sharp rise in defaults could have a large negative impact on the real economy given the importance of leveraged loans as a source of corporate funding," the IMF officials wrote.