Study Warns of Growing Systemic Risks in US Leveraged Loan Market

A new study from the University of Bath raises alarms about the growing systemic risks in the US leveraged loan market, suggesting the potential for another financial crisis. The study identifies several concerning trends, including the underpricing of loans, the significant role of less-regulated non-bank lenders, and the decline in loan standards. Leveraged loans, which are extended to companies with high debt or weaker credit histories, are becoming increasingly risky, with default rates reaching a four-year high of 7.2% in December 2024.

The study points to the weakening pricing of leverage risk since 2014, with the risk premium declining most for the riskiest borrowers. This trend reflects structural weaknesses in the leveraged lending landscape. The rise of non-bank lenders, or 'shadow lenders,' who operate with less regulatory oversight than traditional banks, is another critical factor contributing to the market's instability. Additionally, the surge in Collateralized Loan Obligation (CLO) issuance, which now accounts for approximately 70% of the US leveraged loan market, creates complex and opaque structures that may obscure the true risk to investors.

Further exacerbating the risk is the widespread adoption of 'covenant-lite' loans, which offer fewer protections for lenders and more flexibility for borrowers, making it harder to mitigate losses in times of financial distress. Regulators are increasingly concerned about the rapid growth and interconnections within the private credit market, warning that any significant disruption could threaten financial stability. While past assessments suggested leveraged lending did not pose a significant threat during the COVID-19 pandemic, the current environment of underpriced risk and diminished oversight presents new challenges.