Financial institutions' leveraged loan and CLO exposures are manageable relative to sector capital but risks may rise sharply in a stress, Fitch Ratings says in a new report. Undrawn facilities may be called on leading up to or during a leveraged loan downturn. Banks extend a mixture of credit facilities to CLO managers, investment funds and other non-bank commercial lenders, which are collateralised by leveraged loans or CLOs.

Large US banks on average had exposure to leveraged loans equivalent to 29% of common equity Tier 1 capital at end-2018, based on the limited disclosures available.

"Our corresponding estimates for large European and large Japanese banks are 27% and up to 16%, respectively, although definitions vary by bank. In addition, there is significant exposure to CLOs, particularly among Japanese and US banks," Fitch said.

These exposures appear moderate at a sector level. However, some banks have significantly higher direct exposure and may have built concentrations or taken riskier positions. We estimate that the banks most active in the leveraged loan market have direct loan and CLO exposures averaging 30%-40% of capital.

US life insurers have substantial CLO holdings, typically in upper mezzanine and senior notes, driven by their search for yield during a prolonged period of low interest rates. The sector's exposure was about 20% of total adjusted capital at end-2018 but holdings still only represent about 3% of overall bond holdings, and about 80% are investment grade.

Non-bank financial institutions are increasingly active in underwriting, syndication, direct lending and more aggressive parts of leveraged lending, such as leveraged buyouts and dividend recapitalisations. Investment funds are active purchasers and are more likely to hold riskier junior tranches. Open-ended funds that hold large amounts of less-liquid leveraged loans are exposed to liquidity risk, particularly if spikes in redemptions raise the prospect of fire sales. If banks or investment managers step in to support funds, contagion back to the banking sector may increase.

Second-order effects from a market shock could also be significant, particularly if financing for leveraged borrowers dries up. Non-bank financial institutions could be more at risk given their weaker funding profiles and less diversified business mix, and liquidity risk could be particularly acute for open-ended funds that hold large amounts of less-liquid leveraged loans.