## CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS

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### Market expansion and recent stress
- High-yield bond, leveraged loan, and private debt markets have grown significantly and become more complex over the past decade.
- In the COVID-19 outbreak:
  - Markets for high-yield bonds and leveraged loans experienced sharp declines—European markets had experienced market declines of nearly two-thirds of the falls seen during the global financial crisis.
  - Liquidity deteriorated with exceptionally high bid-ask spreads, amplifying asset price moves.
- Since late March:
  - Credit spreads have retraced a portion of their earlier widening and bid-ask spreads have largely normalized owing to rapid and bold policy responses.
  - Earnings forecasts have continued to decline and credit rating downgrades have gained momentum.

### Size, issuance, and ecosystem exposure (exact measures)
- Market sizes and amounts outstanding:
  - Global leveraged loans outstanding reached $5 trillion globally by end-2019, of which $4 trillion was in advanced economies.
  - Global high-yield bonds outstanding climbed to $2.5 trillion globally by end-2019, of which $2 trillion was in advanced economies.
  - Private debt market reached nearly $1 trillion.
  - Global Leveraged Loans: $4 tn (alternative listing).
  - Global High-Yield Bonds: $1.9 tn (alternative listing).
  - Private Debt Market: $0.7 trillion (alternative listing).
- CLOs and related:
  - CLOs: $750 bn.
  - Middle Market CLOs: $60 bn.
  - CLO managers: $40 bn.
  - US and EU CLOs outstanding more than doubled since 2010.
- Figure 2.1 annotations:
  - 10-year growth = 78 percent (panel 1)
  - 10-year growth = 217 percent (panel 3)
  - 10-year growth = 116 percent (panel 5)
- Ecosystem exposure estimates (Figure 2.3):
  - Mutual funds: $330 bn
  - Pensions: $115 bn
  - Insurers: $145 bn
  - Hedge funds: $320 bn
  - Mutual funds and ETFs (aggregate): $900 bn
  - Private Debt Funds: $540 bn
  - Private debt funds—Global Loans (not syndicated)/Private Credit: $0.7 tn
  - Banks: $1.9 tn (of which Term loan A’s $620 bn; Revolving credit drawn $640 bn; Revolving credit undrawn $640 bn)
  - Business Development Companies: $100 bn

### Changing investor base, interconnections, and leverage magnitudes
- Investor shifts and holdings:
  - Banks shifted from an originate-to-retain to an originate-to-distribute model; banks’ direct exposures to credit risk have declined.
  - Mutual funds and ETFs account for about half of demand for high-yield bonds in the US market.
  - CLOs hold about one-quarter of global leveraged loans and account for more than 60 percent of institutional loans outstanding.
  - CLO investor composition (US, 2019): AAA tranche holders skew toward banks; mezzanine and equity tranche investors include asset managers, hedge funds, insurers, pensions, and others.
  - Private debt growth is driven by institutional investors with long-term locked-in capital who are not required to mark positions to market.
- Average leverage, end of 2019 (reported magnitudes):
  - CLOs (10× debt to equity)
  - Global Leveraged Loans (5.2× debt to EBITDA)
  - Global Loans (not syndicated)/Private Credit (5.6× debt to EBITDA)
  - Global High-Yield Bonds (5× debt to EBITDA)
  - Middle-Market CLOs (10× debt to equity)
  - Business Development Companies (Up to 2× debt to equity)
- Interconnections:
  - Bank lending to nonbank financial institutions has nearly doubled since 2013, reaching $1.4 trillion in the United States.

### Key vulnerabilities identified
- Credit and structural vulnerabilities:
  - Weaker credit quality of borrowers and increased borrower leverage, especially in nonbank-financed deals and smaller (middle-market) firms.
  - Looser underwriting standards and eroded investor protections (weaker covenants, thinner loss-absorbing loan buffers).
  - Liquidity risk at investment funds and open-ended vehicles offering daily redemptions against illiquid underlying instruments.
  - Increased concentration of lenders within lender types and higher interconnectedness across banks, CLOs, mutual funds, insurers, hedge funds, and private debt vehicles.
  - Increased complexity and opacity, notably in private debt markets.
- Offsetting developments:
  - Declines in financial leverage by investors and reduced direct bank exposures are positive developments.
  - Prevalence of long-term locked-in capital in CLO and private debt markets has diminished run risk.

### Credit quality, structural features, and covenant deterioration
- Ratings and CLO structure:
  - Expansion of B-rated credit and deterioration in CLO risk ratings during the long credit cycle.
  - Current CLO structures have less embedded leverage than pre-global financial crisis CLOs (higher share of equity and mezzanine debt rated A and below).
  - A growing concentration of lower-rated credit has raised the potential impact of rating downgrades.
  - Equity cushions can erode quickly, bringing losses to equity holders and even investors holding lower-rated debt.
- CLO tranche liability structure used in Monte Carlo estimation:
  - Equity tranche: 11.8 percent of liabilities.
  - A–1 notes (rated AAA): 60.5 percent of liabilities.
  - A–2 notes (rated AA): 11.5 percent of liabilities.
  - B tranche (rated A): 6.4 percent of liabilities.
  - C tranche (rated BBB): 6.4 percent of liabilities.
  - D tranche (rated BB): 3.4 percent of liabilities.
- Covenant quality and recovery risk:
  - Moody’s Bond Covenant Quality Indicator (BCQI) and Loan Covenant Quality Indicator (LCQI) show weakening covenant protection; higher scores equal weaker covenants.
  - Debt-service ability has steadily weakened since 2015, particularly in middle-market firms.
  - Recovery values may be lower in this downturn because of weaker covenants and reduced loss absorption capacity in the leveraged loan market.
  - Typical overcollateralization test thresholds usually between 5 percent and 20 percent; rising share of assets rated CCC or below and failing overcollateralization tests are CLO pressure points.

### Performance metrics, fund liquidity, and refinancing risks
- Leverage and coverage:
  - Leverage is higher for smaller companies and for deals sponsored by private equity firms.
  - Leverage for deals financed by nonbank financial institutions has risen faster than for those with loans held by banks.
  - Interest coverage ratios have continued to decline, particularly for middle-market firms (firms with earnings below $50 million).
- Maturity and refinancing:
  - A record amount of leveraged loans will mature in five years; global figure: $4 trillion due over five years.
  - Maturing debt is concentrated in lower-rated loans.
- Fund liquidity and flows:
  - Growth of fixed-income funds with relatively illiquid holdings raises the risk that large withdrawals could contribute to asset price moves and deteriorating liquidity.
  - Fund outflows have become more volatile.
  - US open-ended high-yield bond and leveraged loan funds experienced $42 billion in outflows in the fourth quarter of 2018; these outflows accounted for 7 percent (high-yield) and 12 percent (loan funds) of assets under management in that episode.
  - Between late February and the end of March 2020, US open-ended high-yield bond and leveraged loan funds experienced $34 billion in outflows.
  - More recently, high-yield bond funds have seen inflows, and outflows from leveraged loans have slowed markedly, reflecting quarter-end rebalancing and renewed demand.
- Liquidity buffers:
  - In the 2018:Q4 episode, funds were able to meet redemptions without severe market-functioning dislocations, reflecting varying liquidity management strategies across funds and sufficient liquidity buffers in aggregate; however, that episode was short-lived and against continued growth.
- Downside risk:
  - Longer-lasting episodes of market distress, especially if accompanied by a recession, may lead to more severe liquidity strains in the future.

### Severe adverse scenario: calibration, losses, and distributional effects
- Scenario design and assumptions:
  - Applies the credit rating transition matrix estimated for speculative grade credit after the global financial crisis to current credit rating compositions of the high-yield bond and leveraged loan markets to obtain downgrades and defaults.
  - Recovery rate on high-yield bonds is the same as during the global financial crisis; recovery rate on leveraged loans is assumed to be 20 ppts lower than during the global financial crisis.
  - Market prices experience the same declines as during the global financial crisis.
  - Additional amplification mechanisms: sales by investment funds and a reduction in CLO demand for leveraged loans.
  - The scenario considers only direct exposures of banks, nonbank financial institutions, and CLOs to risky credit markets; second-round effects are not included.
- Scenario calibration (selected figures as presented):
  - Three-year default rate242727
  - Recovery rate254545
  - Credit loss rate61212
  - Market price decline–34–40...
- Monte Carlo simulation assumptions (CLO loss estimation):
  - Portfolio: 100 senior secured first lien loans.
  - Adjusted weighted average life: 4.894 years.
  - Weighted average rating: B.
  - Expected portfolio default rate: 15.9 percent.
  - Simulation runs: 10,000.
- Aggregate losses:
  - Overall losses are substantial, totaling more than $1¼ trillion (or almost 20 percent of total exposures) in the scenario.
- Distribution of losses:
  - Investors in CLO equity and mezzanine debt tranches and those with mark-to-market positions (mutual funds and ETFs) have higher nominal losses.
  - Banks have the lowest loss rates (share of exposures) because they hold mostly senior loans with the highest recovery rates and highly rated CLO debt with negligible losses.
  - Hedge funds and mutual funds and ETFs with CLO equity tranche holdings and mark-to-market exposures have the highest loss rates.
  - Many large banks incur losses in excess of 10 percent of their total buffers (sum of capital and loan loss reserves) in the severe adverse scenario.
  - Estimated losses represent only the direct and partial impact from risky corporate credit markets and may understate broader losses from other exposures.

### Key empirical and market observations uncovered by the crisis
- Market moves and drivers:
  - Market price declines in the high-yield bond and leveraged-loan markets reached two-thirds of the descent during the global financial crisis in March, but the speed of deterioration has been unprecedented.
  - Drivers amplifying investor perception of credit risk include elevated borrower leverage, earnings addbacks, sectoral structural weaknesses, weak covenants and reduced investor protections, and large shares of weak credit.
- Market functioning:
  - Selling pressure driven by broad demand for cash raised liquidity risk: sharp declines in new issuance of risky credit during the COVID-19 outbreak, record-high bid-ask spreads on corporate bonds in March, and deep ETF price discounts in March.
  - Interconnectedness across risky credit markets and the global investor base contributed to market dislocations.
  - Mutual funds experienced large outflows (though outflows moderated more recently).
  - Committed but uninvested capital (“dry powder”) does not appear to have been deployed yet.

### Crisis management, policy implications, and recommended priorities
- Immediate crisis priorities:
  - Policymakers should act decisively to contain the economic fallout of the COVID-19 outbreak and support the flow of credit to firms.
  - Authorities in major economies have provided considerable support through monetary, fiscal, and financial policies, and major central banks have initiated or increased purchases of investment-grade corporate debt.
  - Examples of central bank actions:
    - The US Federal Reserve established two facilities for investment-grade corporate debt—the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility.
    - The European Central Bank expanded its Corporate Sector Purchase Program; the Bank of England increased the size of its Corporate Bond Purchase Scheme; the Bank of Japan increased auction amounts of outright purchases of commercial paper and corporate bonds.
    - The US Federal Reserve extended support to some investment-grade bonds downgraded to speculative grade after March 22, some ETFs invested in high-yield bonds, newly issued highly rated CLO tranches, and some small- and medium-sized enterprises whose leverage remains below specified thresholds.
    - The Federal Reserve’s Term-Asset Loan Facility expanded eligible collateral to include AAA tranches of static CLO deals issued after March 23, 2020.
    - The Main Street New Loan Facility limits eligibility to borrowers that do not have debt higher than four times 2019 adjusted EBITDA; the Main Street Expanded Loan Facility has a debt limit of six times 2019 adjusted EBITDA.
- If conditions worsen:
  - If financial conditions deteriorate further and credit downgrades and defaults rise meaningfully, authorities may consider further extending support to risky credit markets to maintain credit flow and prevent severe, prolonged disruptions to firms and the broader economy.
- Supervisory guidance for banks:
  - Supervisors should continue to monitor the banking sector to ensure banks can provide funding to speculative-grade firms.
  - Banks’ existing capital and liquidity buffers should be used to absorb financial costs of customer loan restructuring and to relieve pressures on banks’ funding and liquidity, using full flexibility within existing regulatory frameworks.

### After the crisis — medium-term policy priorities
- Post-crisis assessment and reform:
  - Once the COVID-19 crisis is contained, authorities should conduct a comprehensive analysis to identify the sources of market dislocations and assess vulnerabilities that have been unmasked.
  - Given the large role of nonbank financial institutions in risky credit markets, authorities may consider whether a widening of the regulatory and supervisory perimeter to include nonbank financial institutions active in risky credit markets may be warranted.
  - A framework for macroprudential regulation of nonbank financial institutions should be developed, taking into consideration the global nature of these markets; such a framework is largely absent.
  - The macroprudential toolkit should be expanded to account for the growing importance of nonbank financial institutions.
- Data, transparency, and international cooperation:
  - Policymakers should promote greater transparency in credit markets and ensure authorities have sufficient data to analyze risks stemming from current origination practices and chains of intermediation.
  - Cross-border and global exposures to risky credit markets should be better measured.
  - Bank supervisors in key economic areas should collaborate on data sharing to take account of macro-financial interconnections domestically and internationally.

*International Monetary Fund | April 2020 — Chapter excerpt*

### Chapter 2 at a Glance

### Chapter 2 at a Glance

### Market expansion and recent stress
- High-yield bond, leveraged loan, and private debt markets have grown significantly and become more complex over the past decade.
- In the COVID-19 outbreak: markets for high-yield bonds and leveraged loans experienced sharp declines—European markets had experienced market declines of nearly two-thirds of the falls seen during the global financial crisis—liquidity deteriorated with exceptionally high bid-ask spreads, amplifying asset price moves.
- Since late March, credit spreads have retraced a portion of their earlier widening and bid-ask spreads have largely normalized owing to rapid and bold policy responses, but earnings forecasts have continued to decline and credit rating downgrades have gained momentum.

### Size and issuance (exact measures)
- Global leveraged loans outstanding reached $5 trillion globally by end-2019, of which $4 trillion was in advanced economies.
- Global high-yield bonds outstanding climbed to $2.5 trillion globally by end-2019, of which $2 trillion was in advanced economies.
- Private debt market reached nearly $1 trillion.
- US and EU CLOs outstanding more than doubled since 2010.
- Figure 2.1 annotations:
  - 10-year growth = 78 percent (panel 1)
  - 10-year growth = 217 percent (panel 3)
  - 10-year growth = 116 percent (panel 5)
- Ecosystem exposure estimates (Figure 2.3):
  - Mutual funds: $330 bn
  - Pensions: $115 bn
  - Insurers: $145 bn
  - Hedge funds: $320 bn
  - Mutual funds and ETFs (aggregate): $900 bn
  - Private Debt Funds: $540 bn
  - Private debt funds—Global Loans (not syndicated)/Private Credit: $0.7 tn
  - Banks: $1.9 tn (of which Term loan A’s $620 bn; Revolving credit drawn $640 bn; Revolving credit undrawn $640 bn)
  - Global Leveraged Loans: $4 tn
  - Global High-Yield Bonds: $1.9 tn
  - CLOs: $750 bn
  - Middle Market CLOs: $60 bn
  - Business Development Companies: $100 bn
  - CLO managers: $40 bn

### Changing investor base and interconnections
- Banks shifted from an originate-to-retain to an originate-to-distribute model; banks’ direct exposures to credit risk have declined.
- Mutual funds and ETFs account for about half of demand for high-yield bonds in the US market; CLOs and banks account for a large share of leveraged loan holdings globally.
- CLOs hold about one-quarter of global leveraged loans and account for more than 60 percent of institutional loans outstanding.
- CLO investor composition (US, 2019): AAA tranche holders skew toward banks; mezzanine and equity tranche investors include asset managers, hedge funds, insurers, pensions, and others.
- Private debt growth is driven by institutional investors with long-term locked-in capital who are not required to mark positions to market, increasing opacity but reducing some liquidity risk.
- Private debt vehicles and CLOs benefit from long-term locked-in capital; capital call lines and bank credit lines provide leverage to private credit funds.

### Key vulnerabilities identified
- Weaker credit quality of borrowers and increased borrower leverage, especially in nonbank-financed deals and smaller (middle-market) firms.
- Looser underwriting standards and eroded investor protections (weaker covenants, thinner loss-absorbing loan buffers).
- Liquidity risk at investment funds and open-ended vehicles offering daily redemptions against illiquid underlying instruments.
- Increased concentration of lenders within lender types and higher interconnectedness across banks, CLOs, mutual funds, insurers, hedge funds, and private debt vehicles.
- Increased complexity and opacity, notably in private debt markets.
- Despite vulnerabilities, declines in financial leverage by investors and reduced direct bank exposures are positive developments; prevalence of long-term locked-in capital in CLO and private debt markets has diminished run risk.

### Credit quality and structural features
- Ratings deterioration: expansion of B-rated credit and deterioration in CLO risk ratings during the long credit cycle.
- Current CLO structures have less embedded leverage than pre-global financial crisis CLOs (higher share of equity and mezzanine debt rated A and below), implying greater cushion for AAA tranche holders but larger potential losses for equity and mezzanine investors.
- CLO pressure points: rising share of assets rated CCC or below and failing overcollateralization tests (typical overcollateralization test thresholds usually between 5 percent and 20 percent).

### Performance metrics and underwriting concerns (selected observations)
- Leverage is higher for smaller companies and for deals sponsored by private equity firms; leverage for deals financed by nonbank financial institutions has risen faster than for those with loans held by banks.
- Leveraging in US loan market may be underestimated due to significant earnings adjustments and inflated goodwill.
- Interest coverage ratios have continued to decline, particularly for middle-market firms (firms with earnings below $50 million).
- Following the COVID-19 outbreak, primary markets for risky credit reportedly became more disciplined with higher spreads, more protections, and less leverage.

### Stress scenario implication
- In a severe adverse scenario, total losses at nonbank financial institutions could be substantial, while risk to the banking sector appears to be lower.

*Source: Chapter 2, "Risky Credit Markets: Interconnecting the Dots," Global Financial Stability Report: Markets in the Time of COVID-19 (April 2020).*

### CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS

### CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS

### Embedded and Financial Leverage
- Financial leverage in the United States appears to have declined significantly since the global financial crisis:
  - Total Return Swap lines: 2007 $250 billion 8–10×; Today ~<$75 billion ~3–4×.
  - CLO Warehouses: 2007 $330 billion; Today ~ $50 billion.
  - CLO-related other lines: 2007 $40–50 billion; Today $15 billion.
- New CLOs have a larger equity cushion than precrisis CLOs, but:
  - A growing concentration of lower-rated credit has raised the potential impact of rating downgrades and has translated into deterioration in CLO risk ratings.
  - Equity cushions can erode quickly, bringing losses to equity holders and even investors holding lower-rated debt.
- Risk management and structuring changes:
  - Use of repurchase transactions to fund CLO AAA tranches is reportedly limited.
  - Total-return swaps are not widely employed to gain leveraged exposure to the loan market.
  - Banks appear more conservative on pipeline risk (amount of underwritten risk in new loans they will hold).
  - CLO warehouse lines now often assign the portfolio manager or third parties to take first-loss risks, not the banks (Figure 2.5, panel 5).
- Despite declines in direct investor leverage, interconnections with nonbank financial institutions have risen:
  - Bank lending to nonbank financial institutions has nearly doubled since 2013, reaching $1.4 trillion in the United States (Figure 2.5, panel 6).

### Refinancing and Liquidity Risks
- Maturity concentration:
  - A record amount of leveraged loans will mature in five years; global figure: $4 trillion due over five years (Figure 2.6, panel 1).
  - Maturing debt is concentrated in lower-rated loans; examples: US leveraged loan maturity profile shows substantial amounts for single-B and lower ratings (Figure 2.6, panel 2).
- Fund liquidity and flows:
  - Growth of fixed-income funds with relatively illiquid holdings raises the risk that large withdrawals could contribute to asset price moves and deteriorating liquidity.
  - Fund outflows have become more volatile (Figure 2.6, panel 3).
  - US open-ended high-yield bond and leveraged loan funds experienced $42 billion in outflows in the fourth quarter of 2018; these outflows accounted for 7 percent (high-yield) and 12 percent (loan funds) of assets under management in that episode (Emerging Portfolio Fund Research data).
  - Between late February and the end of March 2020, US open-ended high-yield bond and leveraged loan funds experienced $34 billion in outflows.
  - More recently (as of the period covered), high-yield bond funds have seen inflows, and outflows from leveraged loans have slowed markedly, reflecting quarter-end rebalancing and renewed demand.
- Liquidity buffers:
  - In the 2018:Q4 episode, funds were able to meet redemptions without severe market-functioning dislocations, reflecting varying liquidity management strategies across funds and sufficient liquidity buffers in aggregate; however, that episode was short-lived and against continued growth.
- Downside risk:
  - Longer-lasting episodes of market distress, especially if accompanied by a recession, may lead to more severe liquidity strains in the future.

### Concentration Risk and Interconnectedness
- Primary market concentration:
  - In the primary leveraged loan market, exposures are concentrated among a few large global banks and nonbank financial institutions (Figure 2.7, panel 1).
  - Top lenders account for a large share of the market.
- Secondary market concentration:
  - Several large banks account for significant portions of the speculative-grade credit and CLO markets (Figure 2.7, panel 2).
  - Large non-US banks are heavily involved and are more sensitive to rating downgrades because of steeper capital charges under the new Basel securitization framework and greater exposure to changes in hedging costs.
- Investment fund concentration:
  - Large fund families can hold concentrated positions in lower-rated segments of the bond market; CCC borrowers show greater concentration risk than higher-rated high-yield credits (Figure 2.7, panel 3).
  - Cross-asset holdings by high-yield and loan funds could trigger price spillovers during market stress, and correlations between returns of bonds and loans have spiked during recent market stress episodes (Figure 2.7, panel 5).
- Systemic exposure channels:
  - Speculative-grade credit exposures are estimated from Pillar 3 disclosures and include leveraged loans and high-yield bonds, as well as some small- and medium-sized-enterprise loans and some emerging market loans.
  - CLO exposures are estimated as a summation of holdings as originator, sponsor, and investor in the banking book (SEC1).

### Leverage, Covenant Quality, and Recovery Risk
- Leverage in the loan market has risen, primarily for deals financed by nonbank financial institutions, smaller deals, and private equity-sponsored transactions (Figure 2.4):
  - Increased share of leveraged loan deals with leverage >5 (percent).
  - Total debt-to-EBITDA ratios for newly issued US leveraged loans have increased (ratio).
  - Interest coverage ratios (EBITDA-to-interest-expense) have weakened.
- Covenant quality deterioration:
  - Moody’s Bond Covenant Quality Indicator (BCQI) and Loan Covenant Quality Indicator (LCQI) show weakening covenant protection; higher scores equal weaker covenants.
  - Debt-service ability has steadily weakened since 2015, particularly in middle-market firms.
  - Recovery values may be lower in this downturn because of weaker covenants and reduced loss absorption capacity in the leveraged loan market.
- Debt cushion and lien structures:
  - New-issue leveraged loan debt cushions and first-lien-only loan structures (percent of new issuance) indicate diminished loss absorption in some deal structures.

### Table of Key Vulnerabilities in Risky Credit Markets (summary)
- High-Yield Bond Market
  - Size: $1.9 trillion
  - Valuations: High valuations before the COVID-19 outbreak
  - Borrower’s Leverage: High firm leverage; EBITDA add-backs; Large share of B credit; LBO activity
  - Embedded and Financial Leverage: Active CDX market
  - Liquidity, Maturity, FX Mismatches: Fund outflows can be sizable
  - Concentration: Top borrowers represent a sizable share of the market
  - Interconnectedness: Borrowers in both HY and LL markets; Correlations of HY and LL credit; Crossover funds’ investments in both HY and LL
  - Complexity and Opacity: Low transparency of the riskiness of investors’ exposures
- Leveraged Loan Market
  - Size: $4.0 trillion
  - Embedded and Financial Leverage: Repo, TRS, CLO warehouse lines have declined; Bank credit lines can be quickly repriced
  - Concentration: Top lenders account for a large share of the market
- Private Debt Market
  - Size: $0.7 trillion
  - Valuations/Targets: Limited data on prices; High return targets
  - Liquidity/Maturity: Capital call lines of credit; Large locked-in capital and HTM positions
  - Concentration & Interconnectedness: Lenders in both LL and PD markets
  - Complexity and Opacity: Low visibility of borrowers, investors, and transactions

### Key Statistics and Figures (selected exact values cited)
- Bank lending to nonbank financial institutions in the United States: $1.4 trillion.
- US open-ended high-yield bond and leveraged loan funds outflows:
  - Q4 2018: $42 billion.
  - Late February to end-March 2020: $34 billion.
- Global leveraged loan and high-yield maturity: $4 trillion due over five years.
- Market sizes:
  - High-Yield Bond Market: $1.9 trillion.
  - Leveraged Loan Market: $4.0 trillion.
  - Private Debt Market: $0.7 trillion.
- CLO liability structure used in Monte Carlo estimation:
  - Equity tranche: 11.8 percent of liabilities.
  - A–1 notes (rated AAA): 60.5 percent of liabilities.
  - A–2 notes (rated AA): 11.5 percent of liabilities.
  - B tranche (rated A): 6.4 percent of liabilities.
  - C tranche (rated BBB): 6.4 percent of liabilities.
  - D tranche (rated BB): 3.4 percent of liabilities.
- Monte Carlo simulation assumptions:
  - Portfolio: 100 senior secured first lien loans.
  - Adjusted weighted average life: 4.894 years.
  - Weighted average rating: B.
  - Expected portfolio default rate: 15.9 percent.
  - Simulation runs: 10,000.

*International Monetary Fund | April 2020*

### 1. Amounts Outstanding of Credit Provided by Bank and Nonbank Lenders in the Primary Market for Global Leveraged Loans

### 1. Amounts Outstanding of Credit Provided by Bank and Nonbank Lenders in the Primary Market for Global Leveraged Loans

### Concentration, interconnectedness, and investor exposures
- More than $130 billion in high-yield debt is subject to concentration risk—defined as debt issued by firms where an investment fund family owns more than 10 percent of debt.
- Investment funds, in aggregate, own a larger-than-average portion of debt for firms with concentrated holdings.
- High-yield and loan funds have material holdings across debt markets, increasing the potential for higher price correlations during stress episodes.
- Correlation between leveraged loan and high-yield bond returns tends to rise during market downturns, including during the COVID-19 episode.

### Layers of leverage and bank–nonbank linkages
- Leverage in the market can take three forms: debt issued by firms; leverage embedded in structured finance vehicles, such as CLOs; and financial leverage in the credit system.
- Layering of leverage (leverage on top of leverage) can amplify downward price moves through feedback loops.
- Examples of financial leverage and links in the intermediation chain highlighted:
  - CLO warehouse lines
  - Capital call lines
  - Financial leverage (lines of credit)
  - Financial leverage (repo and derivatives)
- Use of financial leverage in credit markets (credit lines, repurchase agreements, derivatives) is reported as limited compared with the period preceding the global financial crisis, but data availability and opacity make assessment primarily qualitative.
- Capital call lending is a growing asset class for banks, driven largely by private debt funds seeking enhanced returns; this can worsen losses at private debt funds and increase credit and liquidity risks for banks.

### Risky credit market ecosystem and leverage magnitudes (Average leverage, end of 2019)
- CLOs (10× debt to equity)
- Global Leveraged Loans (5.2× debt to EBITDA)
- Global Loans (not syndicated)/Private Credit (5.6× debt to EBITDA)
- Global High-Yield Bonds (5× debt to EBITDA)
- Middle-Market CLOs (10× debt to equity)
- Business Development Companies (Up to 2× debt to equity)

### Severe adverse scenario: assumptions and mechanics
- The scenario applies the credit rating transition matrix estimated for speculative grade credit after the global financial crisis to current credit rating compositions of the high-yield bond and leveraged loan markets to obtain downgrades and defaults.
- Recovery rate on high-yield bonds is the same as during the global financial crisis; recovery rate on leveraged loans is assumed to be 20 ppts lower than during the global financial crisis to account for reduced credit protections.
- Market prices experience the same declines as during the global financial crisis.
- Additional amplification mechanisms are assumed: sales by investment funds and a reduction in CLO demand for leveraged loans.
- The scenario considers only direct exposures of banks, nonbank financial institutions, and CLOs to risky credit markets; second-round effects (for example, banks’ lending to nonbank lenders that suffer losses) are not included.

### Scenario calibration (Table 2.2 — key assumptions as presented)
- Note: The table presents assumptions about defaults, recoveries, and market price declines, and types of losses by asset class and lender type, reproduced as in source.
- Three-year default rate242727
- Recovery rate254545
- Credit loss rate61212
- Market price decline–34–40. . .
- “Credit” refers to held-to-maturity exposures that incur credit losses.
- “Market” is for mark-to-market exposures that incur market losses.
- “Model” is for exposures to CLO mezzanine debt and equity that are mark-to-market based on a standard overcollateralization test.

### CLO effects and overall losses in the scenario
- Because of a larger proportion of B credit than in the past, a median CLO’s credit quality deteriorates quickly in the scenario.
- Mark-to-model losses affect 27 percent of the capital stack, reaching mezzanine debt (A and below) in the scenario, while leaving AAA–AA investors unaffected.
- During the recent COVID-19 outbreak, weaker CLOs—with a high share of CCC credits—have already started to incur mark-to-model losses amid mounting credit rating downgrades.
- Overall losses are substantial, totaling more than $1¼ trillion (or almost 20 percent of total exposures) in the scenario.
- Investor-type losses:
  - Investors in CLO equity and mezzanine debt tranches and those with mark-to-market positions (mutual funds and ETFs) have higher nominal losses.
  - Banks have the lowest loss rates (share of exposures) because they hold mostly senior loans with the highest recovery rates and highly rated CLO debt with negligible losses.
  - Hedge funds and mutual funds and ETFs with CLO equity tranche holdings and mark-to-market exposures have the highest loss rates.
- Many large banks incur losses in excess of 10 percent of their total buffers (sum of capital and loan loss reserves) in the severe adverse scenario.
- Profits would be the first line of defense but are likely to decline during a recession; estimated losses represent only the direct and partial impact from risky corporate credit markets and may understate broader losses from other exposures.

### Key empirical and market observations uncovered by the crisis
- Market price declines in the high-yield bond and leveraged-loan markets reached two-thirds of the descent during the global financial crisis in March, but the speed of deterioration has been unprecedented.
- Drivers amplifying investor perception of credit risk:
  - Elevated borrower leverage
  - Earnings addbacks
  - Sectoral structural weaknesses
  - Weak covenants and reduced investor protections
  - Large shares of weak credit
- Selling pressure driven by broad demand for cash raised liquidity risk:
  - Sharp declines in new issuance of risky credit during the COVID-19 outbreak
  - Record-high bid-ask spreads on corporate bonds in March
  - Deep ETF price discounts in March
- Interconnectedness across risky credit markets and the global investor base contributed to market dislocations.
- Mutual funds experienced large outflows (though outflows moderated more recently).
- Committed but uninvested capital (“dry powder”) does not appear to have been deployed yet.

### Policy implications and recommended priorities
- Policymakers should act decisively to contain the economic fallout of the COVID-19 outbreak and support the flow of credit to firms; once the crisis is over, assess sources of market dislocations and tackle vulnerabilities in risky credit markets unmasked by the episode.
- Crisis management tools are the first priority:
  - Authorities in major economies have provided considerable support through monetary, fiscal, and financial policies, and major central banks have initiated or increased purchases of investment-grade corporate debt.
  - The US Federal Reserve established two facilities for investment-grade corporate debt—the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility. The European Central Bank expanded its Corporate Sector Purchase Program; the Bank of England increased the size of its Corporate Bond Purchase Scheme; the Bank of Japan increased auction amounts of outright purchases of commercial paper and corporate bonds.
  - The US Federal Reserve extended support to some investment-grade bonds downgraded to speculative grade after March 22, some ETFs invested in high-yield bonds, newly issued highly rated CLO tranches, and some small- and medium-sized enterprises whose leverage remains below specified thresholds.
  - The Federal Reserve’s Term-Asset Loan Facility expanded eligible collateral to include AAA tranches of static CLO deals issued after March 23, 2020. The Main Street New Loan Facility limits eligibility to borrowers that do not have debt higher than four times 2019 adjusted EBITDA; the Main Street Expanded Loan Facility has a debt limit of six times 2019 adjusted EBITDA.
- If financial conditions deteriorate further and credit downgrades and defaults rise meaningfully, authorities may consider further extending support to risky credit markets to maintain credit flow and prevent severe, prolonged disruptions to firms and the broader economy.
- Supervisory guidance for banks:
  - Supervisors should continue to monitor the banking sector to ensure banks can provide funding to speculative-grade firms.
  - Banks’ existing capital and liquidity buffers should be used to absorb financial costs of customer loan restructuring and to relieve pressures on banks’ funding and liquidity, using full flexibility within existing regulatory frameworks.

*International Monetary Fund | April 2020 — Chapter excerpt*

### CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS

### CHAPTER 2 RISkY CREDIT MARkETS: INTERCONNECTING ThE DOTS

### After the Crisis, Medium-Term Vulnerabilities Should Be Tackled
- Once the COVID-19 crisis is contained, authorities should conduct a comprehensive analysis to identify the sources of market dislocations and assess vulnerabilities that have been unmasked.
- Given the large role of nonbank financial institutions in risky credit markets, and based on the behavior of these institutions during the recent episode, authorities may consider whether a widening of the regulatory and supervisory perimeter to include nonbank financial institutions active in risky credit markets may be warranted. A framework for macroprudential regulation of nonbank financial institutions should be developed, taking into consideration the global nature of these markets. Such a framework is largely absent. The macroprudential toolkit should be expanded to account for the growing importance of nonbank financial institutions (see the October 2019 GFSR).
- Policymakers should promote greater transparency in credit markets. To enable proper assessment of risks in these markets, authorities should ensure that they have sufficient data to analyze risks stemming from current origination practices and chains of intermediation in the corporate debt market. Cross-border and global exposures to risky credit markets should be better measured.
- Bank supervisors in key economic areas should collaborate on data sharing to take account of macro-financial interconnections domestically and internationally. Given the commonality of corporate exposures at large banks and links across banks and nonbank financial institutions, as well as cross-border features of global credit markets, greater international collaboration on data sharing may be desirable to gauge risks in the banking system.

*International Monetary Fund | April 2020*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/ch2.pdf_