Tuesday, May 9, 2023
The Federal Reserve (Fed) released its quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices yesterday and it continues to show banks are tightening lending standards on commercial and industrial (C&I) loans. C&I loans are an important funding source for companies that can’t (or don’t want to) access capital markets to fund growth initiatives or to just help pay the bills. Moreover, C&I loans are an especially important funding source for lower-rated companies because borrowing (or issuing additional equity shares) can be too restrictive and costs prohibitive at times, whereas C&I loans are short-term loans with variable interest rates that are generally secured by company collateral.
However, with the recent Fed report showing banks are making it harder for some companies to access C&I loans and/or only access them at higher rates, it could mean higher yields and spreads for the high-yield index broadly (Bloomberg U.S. Corporate High Yield Index). Shown below, tighter lending standards (orange line) have historically correlated with higher bond yields and spreads (blue line) for non-investment grade rated companies. This relationship makes sense as C&I loans can provide emergency financing for companies if needed and without that potential lifeline, it could make it harder for some companies to service existing debt.
According to the report, the percentage of respondents that reported tightening standards for C&I loans to large and medium firms increased marginally in the past three months, to 46% from 44.8% in the prior survey. However, this report only covers the first quarter, when only SVB (March 10) and Signature Bank (March 12) were thought to be at risk. As the regional banking stresses have continued into the second quarter, it’s likely next quarter’s report will continue to show additional tightening. According to Bloomberg Intelligence, this indicator leads actual lending activity by about 12 months, and has produced an accurate leading signal of recessions in the past. The current value is consistent with a sharper pullback in C&I loans in the second half of the year. C&I lending accounts for 10% of GDP.
And while high-yield companies, in general, did a good job of fortifying balance sheets and terming out debt (i.e., issuing a lot of debt at longer maturities at low interest rates) there will most certainly be companies that will need emergency financing and won’t be able to access it. This in turn will likely lead to defaults, especially if the economy contracts at some point this year. The asset class has been resilient so far though given the ongoing regional banking stresses, debt ceiling debate, and over 5% of Fed rate hikes. But high yield spreads are currently trading around historical averages in a year that feels anything like average. So, while we like high yield from a strategic perspective (for investors with a longer-term time horizon), we remain on the sidelines in tactical portfolios awaiting a better entry point.
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