A woman walks past the Federal Reserve building in Washington, DC. Pressure from the Federal Reserve and the Office of the Comptroller of the Currency on banks to tighten lending standards is rising amid concern that speculative-grade companies are adding too much debt based on overly optimistic assumptions.

Bloomberg/New York

The biggest underwriters of leveraged loans for US companies are preparing for a second straight year of declining volumes as regulators resolve to improve standards of the high-yield, high-risk debt.

The top five banks that arrange the financings and sell pieces to institutional investors such as mutual funds see sales falling, with Barclays and Deutsche Bank forecasting as little as $325bn. That would be down from more than $515bn issued in 2014 and the first back-to-back annual drop since 2009, according to data compiled by Bloomberg.

Pressure from the Federal Reserve and the Office of the Comptroller of the Currency on banks to tighten lending standards is rising amid concern that speculative-grade companies are adding too much debt based on overly optimistic assumptions. The projected slowdown comes as loan interest rates increase, boding ill for lenders who have agreed to finance purchases, such as the pending $8.3bn buyout of pet-store chain PetSmart.

“Large LBOs will be limited by the leveraged-lending guidelines,” Bradley Rogoff, the New York-based head of global credit strategy at Barclays, said in a telephone interview. “We’ve seen increasing scrutiny” from regulators and that should curb the amount of debt used to finance deals this late in the credit cycle.

Regulators have warned of froth in the loan market, which has swelled by about 34% since 2008 to $800bn as the Fed has held its benchmark rate near zero and investors sought the debt for the relatively high yields. Leveraged loans are typically issued by companies rated below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s.

Scrutiny of the debt has intensified after the Fed and the OCC issued lending guidelines in March 2013 due to concern that underwriting standards had deteriorated as the leveraged-loan market ballooned. That year institutional loan sales reached a record $701.8bn, Bloomberg data show.

The guidelines from regulators say that a total debt level exceeding six times Ebitda, or earnings before interest, taxes, depreciation and amortization, “raises concerns” for most industries. Leverage last year for large LBOs rose to an average 5.9 times Ebitda by November, from 5.4 times in 2013, according to S&P’s Capital IQ Leveraged Commentary & Data.

The “rapid” rise in leveraged-loan issuance over the past few years increases the “magnitude of potential losses under a stress scenario,” according to an e-mailed statement from Martin Pfinsgraff, the OCC’s top large-bank supervisor, in July.

Leveraged lending has continued to show serious deficiencies, according to a review released in November by the Fed, OCC and the Federal Deposit Insurance Corp

Banks have begun shying away from underwriting LBO financing that may be considered “non-pass” by regulators, who shifted to a deal-by-deal review to curb risky lending, people with knowledge of the matter said last year.

Bank of America Corp, the top underwriter of US leveraged loans sold to institutional investors last year, forecasts $360bn of issuance in 2015, according to a December 8 report. Credit Suisse Group, the second-biggest lender, expects $340bn, while No 4 JPMorgan Chase & Co projects $400bn. Deutsche Bank ranks third and Barclays fifth among underwriters of institutional loans in 2014, Bloomberg data show.

In 2015 the pace of refinancing in the loan market will decline by about half, adding to a drop in issuance resulting from a “stronger regulatory focus on compliance with lending guidance,” according to a December 5 report from Deutsche Bank.

“There’s not a ton of refinancing that needs to occur,” said Rogoff. “M&A will be a big driving factor.”

Returns from loans are shrinking, with gains of about 1% last year, compared with 5% in 2013, according to the S&P/LSTA US Leveraged Loan 100 index.

The leveraged-finance markets were broadly hurt in December by the plunge in oil, with loan prices tumbling to as little as 93.8 cents on the dollar on December 16, the lowest since July 2012, according to the S&P/LSTA US Leveraged Loan 100 index. The debt should return 3.5% to 4.5% this year as prices rebound, according to Rogoff.

Demand for riskier corporate loans waned last year, with investors pulling a net $20.9bn through Dec. 24 from US mutual funds and exchange-traded funds that invest in the debt, after depositing a record $62.9bn in 2013, according to Lipper.

There’s probably a “better outlook” for 2015 with the “Fed potentially increasing rates in the middle of the year,” said Rogoff. “We don’t expect any massive inflows, but it will help stem the outflows.”

Payments collected from loans are usually tied to floating benchmark rates, unlike bonds, which typically offer fixed coupons.

Borrowing costs rose last year. The average interest margin for new institutional loans was 4.64 percentage points more than lending benchmarks on December 11, up from 3.89 percentage points last January, according to S&P’s Capital IQ LCD.

Buyout financings may become more expensive than banks anticipated before marketing the debt to investors.

Citigroup, Nomura Holdings, Jefferies Group, Barclays and Deutsche Bank have committed $6.2bn to back BC Partners’ purchase of PetSmart. The buyout agreement was announced December 14 and is expected to be completed in the first half of this year, according to a company statement.