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A new study from the University of Bath has found that highly leveraged loans are increasingly underpriced in the U.S. loan market, particularly among non-bank lenders that are not subject to the same oversight as traditional banks, with researchers warning that this systemic issue could trigger a new financial crisis.

Default rates on leveraged loans, which typically are offered to higher risk borrowers with larger debts or poor credit history, are at their highest level in four years. According to the Financial Times, in December 2024, default rates on U.S. leveraged loans climbed to 7.2%, the highest level since the end of 2020. Many borrowers are resorting to distressed exchanges to avoid bankruptcy, reducing investor recoveries and highlighting the fragility of the market.

"Leverage risk is not being accounted for properly and it is very concerning. Our findings show that since 2014, the pricing of leverage risk has weakened dramatically, particularly among shadow lenders offering covenant-lite and securitized loans. The leverage risk premium has declined most for the riskiest borrowers," said Dr. Ru Xie, Associate Professor of Finance at the University of Bath School of Management.

In the study—"Leveraged loans: is high leverage risk priced in"—the researchers warn that this pricing distortion reflects structural weaknesses in the post-2014 leveraged lending landscape. The shift to non-bank credit origination, rapid growth in CLO (collateralized loan obligation) issuance, and declining loan standards have converged to create a dangerous environment where systemic risks may go unrecognized until a crisis emerges, they said. The work is in the International Journal of Banking, Accounting and Finance.

"With today's elevated geopolitical tensions, from trade disruptions to war risk, and amid persistent market uncertainty, underpriced leverage risk becomes more than a credit issue—it becomes a macroprudential concern. If distress spreads across leveraged borrowers, particularly those financed by shadow banks, we could face a new banking or credit crisis that's largely invisible to regulators," said Professor David Newton, co-author of the study.

The researchers identified two key drivers behind the deteriorating risk premium:

• A rise in information asymmetry through the use of covenant-lite structures and non-performance-based pricing. Covenant-lite loans are those without covenant, and banks conduct less monitoring. These loans are more likely to be securitized into different tranches and sold to investors, who usually do not have clear information about the underlying assets.
• A surge in securitization activity, especially CLOs, that transfers risk away from originators and weakens monitoring incentives. In this case, syndicated loans are securitized, and investors—rather than the original lenders—bear the credit risk.

The authors said greater regulatory attention should be paid to the growing role of non-bank lenders and the risks posed by opaque loan packaging and weak documentation standards. They noted that global regulators, including the ECB and Bank of England, have recently expressed similar concerns.