In part I of this series, four credit markets experts from Alvarez & Marsal discussed the economic challenges that 2023 presented, but hinted that 2024 could offer some good news alongside additional financial woes. In part II our experts look at specific issues credit market watchers should pay especially close attention to this year.
Credit Markets and Banking
The Fed spent most of 2023 trying to tamp down inflation by raising interest rates, a path it embarked on starting in March 2022, which subsequently pushed up Treasury yields across all maturities. As interest rates increased, the market concurrently experienced an increase in credit downgrades.
Nevertheless, credit markets showed some signs of life in the second half of the year as inflation fears began to ease.
For 2023, J.P. Morgan forecasted new issuances of leveraged loans and high-yield bonds at $300 billion and $200 billion, respectively. At the current run rate, high-yield bonds will come in slightly below and leveraged loans slightly above this forecast.
New issuances of leveraged loans in 2023 remained subdued and likely ended the year below the new issuance levels of 2022, which were also way off from the record highs achieved in 2021. Additionally, approximately 3.5% of the leveraged loan index is rated CCC, which means these loans are susceptible to non-payment if business conditions are unfavorable.
Moving down the capital stack, high-yield bond issuance was up to $118 billion through the first three quarters of 2023, well below the long-term average, but still significantly higher than the record low of $95.3 billion seen in 2022. However, high-yield bond issuances in September 2023 started to show some signs of resilience as levels returned to that experienced in 2021, indicating that companies may finally be getting more comfortable accessing the capital markets in an elevated interest rate environment.
Additionally, new Collateralized Loan Obligation (CLO) volume is expected to be about $115 billion for 2023, well above 2022 volumes, but still below 2021 levels - an important fact given that CLOs continue to dominate the non-bank leveraged loan issuance market.
Finally, the absence of refinancing activity in 2023 led to the second largest year-over-year decline in the market’s average number of years to maturity, a record low of 5.5 years. Going forward, though many companies may still be wary of issuing debt in this market, the potential for lower borrowing costs in 2024, coupled with increased investor appetite to take on risk, will likely help corporate borrowers “kick-the-can” down the road. High-yield bond and leveraged loan maturities should be manageable through 2024 but will rise to $830 billion in 2025 and 2026, adding uncertainty to the future and increasing the likelihood of a new “maturity wall.”
On a related note, the banking sector is experiencing a complete reversal of the “easy money” conditions it enjoyed between 2009-2021. Recent 40-year inflation highs (although inflation is trending downwards), rising risk aversion and scarce financing are expected to continue in 2024.
Three bank failures destabilized the banking sector in 2023, causing an estimated $30 billion loss to the Federal Deposit Insurance Corporation (FDIC). The response by regulators was to substantially raise regulatory requirements to minimize risk of defaults. Regional banks (those between $80 billion and $120 billion in assets) will likely be hardest hit when it comes to meeting these new regulatory requirements.
About 50% of commercial banks tightened lending standards in 2023, adding to the challenge of increasing interest rates. Even if best case scenarios appear in 2024, commercial bank credit could remain subdued.
The question is whether the adverse situation in some of these banking bailouts will show up in excess tightening in the future. The potential of such behavior has introduced risk to the sector’s outlook. The bottom line is that liquidity may tighten in the near-to-medium term across the board, from secured and high-yield debt to credit provided by regional banks. Regardless of the form of credit, the cost of capital is expected to continue to be elevated over the next few years as compared to the prior decade, which will have ongoing economic implications.
Defaults and Bankruptcies
The ripple effect of all these challenges will show up in bankruptcy courts in 2024.
Challenging conditions are currently evidenced in debt default rates, which rose consistently this past year, but have fallen in recent months. Historically, the default cycle has peaked roughly one to two years after the Fed Funds rate has peaked, which means this lagging effect should happen soon.
The U.S. speculative-grade corporate default rate was 1.9% in August 2023, but could more than double by June 2024 if the economy stumbles or consumers finally begin to pull back on spending.
J.P. Morgan forecasted high-yield bond and leveraged loan default rates to rise to 3.0% and 3.5%, respectively, in 2023 and extend higher in 2024. The good news is that this is below S&P’s pessimistic scenario of 4.75% for high-yield bonds.
Total 2023 expected defaults – combining defaults and distressed exchanges – already ranks as the market’s third largest annual default total, led by media and entertainment, consumer products, healthcare and retail sectors in the U.S, Bloomberg reports.
Corporate funded debt continued its meteoric rise to almost two times higher than just prior to the great recession. Signs of the ever-growing debt load of typical U.S. companies can be seen in the extremely low levels of operating income, especially in key sectors such as retail and media and entertainment.
The number of bankruptcies filed by public and private companies with over $100 million in assets increased during the first half of 2023 to 72 filings, according to S&P Global Market Intelligence. These bankruptcies will more than double 2022’s total, and if the pace continues, it will mark the first time since 2020 that bankruptcies have surpassed 100 over $100 million in assets. Healthcare and retail continue to lead all other sectors in terms of filing for bankruptcy.
Expect defaults to continue to rise as higher interest rates linger. “Higher for longer” could be the mantra over the next two to three years. Core Personal Consumption Expenditure (PCE) prices continued to slow to 3.2% in November, which is at the Fed’s target on both a three- and six-month annualized percent change basis. However, the Federal Open Market Committee’s (FOMC) central estimate for inflation doesn’t have core PCE reaching the 2% target until 2026, which would require a trend shift in inflation slowing soon, according to Citigroup.
Historically, tight credit conditions tend to precede increases in defaults. Look for a further uptick in bankruptcies, led by retail. Charles Schwab predicts bankruptcies peaking by the end of the first quarter, or into the second, potentially leading the U.S. into recession.
What this Means for Credit Market Watchers
Current economic and financial metrics indicate that bankruptcies, tight credit, and defaults will likely continue into the new year.
Tightening credit, perhaps rising unemployment, inflation, and interest rates are factors that will continue to distress retail and consumer-facing companies. Whether a correction in the economy comes or not, at some point factors must reset. The question is not if, but how and when? Will the Fed’s potential interest rate cuts move the needle for consumers and creditors? Can inflation’s continued decline buoy consumer sentiment? Have regulators done enough, soon enough, to stabilize the banking sector?
Answers to all these questions will inform whether the economy will be faced with a recession in the near future.
About the authors: This article was written by four credit markets experts from Alvarez & Marsal: Andrea Gonzalez, Managing Director UCC Practice; Mark Greenberg, Managing Director UCC Practice Co-Chair; Rich Newman, Managing Director UCC Practice Co-Chair; and Seth Waschitz, Senior Director UCC Practice.
Posted at MediaVillage through the Thought Leadership self-publishing platform.
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The opinions expressed here are the author's views and do not necessarily represent the views of MediaVillage.org/MyersBizNet.