Leveraged Credit Risk Grows for US Banks

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Rising Interest Rates Pose Risks to Corporate Credit Market and Banks, FDIC Warns

The Federal Deposit Insurance Corporation (FDIC) has raised concerns about the corporate credit market and its potential risks to U.S. banks. In its 2023 Risk Review of the banking sector, the FDIC highlighted the triple threat of rising interest rates, persistent inflation, and an uncertain economic outlook that has clouded the corporate credit market.

The corporate credit market has been hit hard, with investment-grade corporate bond issuance falling 15% from its peak in 2021. High-yield bond issuance, which tracks lending to companies with subpar credit, has plummeted by a staggering 80%. Syndicated loans, particularly those to the most indebted companies, are also considered risky due to credit risk, or the likelihood that the borrower may default on the loan.

The largest banks are particularly exposed to the corporate credit market, as they hold significant amounts of corporate bonds, bilateral loans, leveraged and syndicated loans, and lending to private parties. Over the past year and a half, corporate lending conditions have worsened due to the highest inflation in four decades, rising interest rates, and economic uncertainty.

Boaz Weinstein of Saba Capital Management warned that with the ongoing challenging borrowing environment, it is almost certain that corporate default rates will continue to rise. The decline in corporate bond issuance began before the Federal Reserve started raising interest rates in an attempt to control inflation. Investment-grade bond issuance fell 15%, and high-yield bond issuance dropped a staggering 80%.

Despite the potential risks, U.S. banks have shown resilience thus far. One mitigating factor is that many borrowers took advantage of low interest rates during the early stages of the pandemic to refinance their loans, which will not mature for several more years. Additionally, interest rate spreads, which measure the difference in yields between corporate bonds and U.S. Treasuries, are not significantly elevated and are close to, if not slightly below, their historical long-run averages. While spreads have widened from their lows in 2021, they remain well below the peaks seen during the onset of the pandemic and the global financial crisis in 2008.

The highest risk lies in exposure to leveraged loans, which are loans to highly indebted companies. These loans have floating interest rates that change over the duration of the loan. The primary risk associated with leveraged loans is credit risk, or the likelihood of the borrower being unable to repay. While the pace of growth in leveraged loan issuance slowed last year, it still amounted to $1.1 trillion. Bank holdings of syndicated loans, including leveraged loans, increased by 20% to over $1.36 trillion in the fourth quarter of 2021. Furthermore, holdings of collateralized loan obligations (CLOs), which are mainly concentrated among the four largest banks, rose by 13% in the first quarter of this year to $173 billion.

In conclusion, the corporate credit market is facing significant challenges due to rising interest rates, persistent inflation, and economic uncertainty. These factors pose risks to U.S. banks, especially those with substantial exposure to the corporate credit market. While banks have shown resilience thus far, the FDIC warns that the ongoing borrowing environment may lead to a rise in corporate default rates. The highest risk lies in leveraged loans, and the increase in syndicated loan holdings and collateralized loan obligations further exacerbate potential vulnerabilities. It remains crucial for banks to closely monitor and manage their exposure to the corporate credit market to ensure stability in the face of these challenges.

Takeaways:

  • Rising interest rates, persistent inflation, and uncertain economic outlook pose risks to the corporate credit market.
  • U.S. banks, with their significant exposure to the corporate credit market, may face increasing vulnerabilities.
  • Investment-grade bond issuance has fallen by 15%, while high-yield bond issuance has plunged by 80%.
  • Leveraged loans and syndicated loans are especially risky due to credit risk.
  • Banks have shown resilience thus far, but corporate default rates may continue to rise in the challenging borrowing environment.
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