The corporate credit market, plagued by rising interest rates, persistent inflation and an uncertain economic outlook, could pose increasing risks to U.S. banks, the Federal Deposit Insurance Corp. (FDIC) said in its 2023 Risk Review of the banking sector.
Key Takeaways
- Corporate credit markets have been hit by a triple whammy of rising interest rates, persistently high inflation, and general economic uncertainty.
- Investment-grade corporate bond issuance has fallen 15% from its 2021 peak, while high-yield issuance has plunged 80%.
- Syndicated loans, or loans to the most indebted companies, are particularly risky due to their credit risk, or the likelihood that the borrower is unable to repay the loan.
The biggest banks have considerable exposure to the corporate credit market due to their vast holdings of corporate bonds, bilateral loans, leveraged and syndicated loans, and lending to private parties. Corporate lending conditions have deteriorated over the past year and a half, amid the highest inflation in four decades, rising interest rates, and general economic uncertainty.
"As this more challenging borrowing environment persists, it won’t be a prognostication but rather a near certainty that corporate default rates will continue to rise," said Boaz Weinstein of Saba Capital Management in a statement to Goldman Sachs.
Corporate bond issuance has declined markedly from its 2021 peak before the Federal Reserve began raising interest rates in an effort to tame soaring inflation. Investment-grade bond issuance, or issuance to companies with higher credit ratings, fell 15%, while high-yield bond issuance—which tracks lending to companies with subpar credit—tumbled a whopping 80%.
While corporate credit risks could pose a threat to banks' stability, U.S. banks have so far been resilient, the FDIC said.
One saving grace is the borrowers who took advantage of low interest rates early in the pandemic to refinance their loans, which won't mature for another several years. Also, interest rate spreads—the difference in yields between corporate bonds and U.S. Treasuries—are not substantially elevated and are near, if not slightly below, their historical long-run averages. While spreads have widened from their 2021 lows, they remain well below peaks hit in early 2020 and late 2008, coinciding with the onset of the pandemic and global financial crisis, respectively.
The highest risk lies in exposure to leveraged loans, or loans to highly indebted companies. Because these are floating interest rate loans, and the interest rate changes over the duration of the loan, the primary risk associated with them is credit risk, or the likelihood that a borrower is unable to repay. Leveraged loan issuance continued to rise last year to $1.1 trillion, though the pace of growth slowed.
Bank holdings of syndicated loans, a category that includes leveraged loans, rose to more than $1.36 trillion in last year's fourth quarter, up 20% from the same quarter of 2021. Meanwhile, holdings of collateralized loan obligations (CLOs), which are mostly concentrated among the four biggest banks, rose 13% in the first quarter to $173 billion.
