Fed’s Leveraged-Lending Stress Test Is a Start to Easing Fears

Fund managers are increasingly concerned about excessive debt on company balance sheets.

(Bloomberg Opinion) — Ask just about anyone on Wall Street what worries them the most, and corporate leverage will most likely rank among their top fears. In August, Bank of America Corp. surveyed 224 fund managers with a combined $553 billion in assets and found that a record 50% of them were concerned about excessive debt on company balance sheets.

It’s not hard to see why that’s the case. For one, a growing number of well-known U.S. companies are now rated triple-B, potentially just one economic downturn from becoming junk and facing a spike in borrowing costs. But at least that’s more or less out in the open. More ominous is the explosive growth in the market for leveraged loans and collateralized loan obligations. Global regulators haven’t found a way to quantify the threat they may pose to the financial system in a worst-case scenario. At least not yet.

The Federal Reserve is apparently ready to take a stab at measuring that risk itself. It announced last week that as part of its annual stress tests, Wall Street’s biggest banks must prove they can withstand a “wave of corporate sector defaults” and outflows from leveraged-loan funds that cause steep enough price declines to flow through into CLO tranches. The scenario anticipates that such a sell-off would also spill over into other types of risky credit and private equity.

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