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Global securities regulators are issuing new guidance that aims to address growing concerns about the markets for leveraged loans and collateralized loan obligations (CLOs).

In a new report, the International Organization of Securities Commissions (IOSCO) highlights regulators’ worries about the evolution of the leveraged loan and CLO markets in the years since the financial crisis — driven in part by the prolonged low interest rate environment.

According to the report, while these markets generally held up well during the global financial crisis, since then they’ve seen significant shifts in market practices, including the adoption of fewer and weaker investor protection covenants, a lack of market transparency and potential conflicts of interest.

IOSCO has previously pointed out the increased risk of default in the leveraged loan sector “due to the large and growing proportion of lower-rated borrowers, a situation which could be exacerbated by the recent changes in monetary policy.”

At the same time, this increased default risk also posed a growing threat of investor losses due to weakening investor protections in loan contracts “through so-called covenant-lite loans,” the report noted.

The regulators further warned that these risks could be exacerbated by certain market practices, such as the “aggressive use of EBITDA adjustments and permissive contract clauses” that may favour the interests of private equity sponsors and corporate borrowers over investors.

“The potential misalignment of interests between bank lenders and [leveraged loan] investors raises further concerns, especially if it results in an imbalance in negotiating powers between borrowers and lenders,” IOSCO said, adding that “CLO managers may have an incentive to manage their CLOs to maximize return on equity rather than protect debt investors in periods of stress.”

To respond to these concerns, the regulators’ report details a series of best practices that aim to toughen investor protection, guard against systemic risk, and ensure that markets are fair, efficient and transparent.

In a release, Christina Choi, chair of the IOSCO committee on investment nanagement, said the practices detailed in the report “are a set of important tools which will help mitigate the vulnerabilities identified during our work, particularly the possible conduct and conflicts of interest risks observed across the intermediation chain.”

“While these measures will provide further support on the usage of existing industry best practices guides, they will also be of great help to jurisdictions that may be looking to develop or expand into these markets,” added James Andronis, chair of the IOSCO committee on regulation of market intermediaries.