The agency said that investors hungry for yield have been willing to tolerate looser protections to the point where they are now weaker than they were even before financial crisis exploded in 2008. Much of that money comes from the institutional side. Exchange-traded funds tracking the loan market hold more than $8 billion in assets, though the largest, the $5.3 billion Invesco Senior Loan fund, has seen about 30 percent of its assets redeemed during the past year.
“The breadth and depth of this weakness poses risks never before faced by leveraged loan investors, and outcomes under these extreme conditions have never been fully tested through a full market cycle,” Gluckman said.
Yellen isn’t the only one warning about the dangers.
Billionaire hedge fund manager Seth Klarman of the Baupost Group told clients in his latest investor letter that highly indebted companies will pose a significant danger should the economy weaken, which he expects to happen soon due in part to both government and corporate debt levels.
“Higher interest rates will significantly burden today’s highly leveraged issuers, and the challenges will be made more severe when the next economic downturn hits,” wrote Klarman, whom many consider to be inheriting Warren Buffett’s mantle as a market sage.
As far as specific threats from the lack of covenants, Moody’s mentions collateral control, guarantees and lien priority as the biggest issues. The agency said some lenders have taken advantage of weak protections to take even greater risks.