This article originally appeared in the World Economic Forum on Dec 3, 2024.
The corporate credit market is undergoing its biggest transformation since large companies started turning in big numbers to the bond market instead of banks for financing in the 1980s. Business and government leaders need to watch this space carefully.
Private debt funds are grabbing market share from banks through direct lending and by creating collateralized loan obligations (CLOs) and more exotic products, while hedge funds are making a splash in corporate bonds and leveraged loans typically aimed at riskier borrowers. An explosion of fixed-income exchange-traded funds (ETFs) is meanwhile exposing more ordinary investors to the bond market, and enhancing liquidity for everyone.
There is plenty to like about these developments. First and foremost, they are improving credit availability by expanding the options for borrowers and investors, according to recent research from the Oliver Wyman Forum — the think tank of global management consultancy Oliver Wyman. The enhanced flow of funds can foster more business investment, hiring, and economic growth. Related products, which are most advanced in the US but spreading to Europe and Asia, also reduce some risks by drawing on long-term capital from insurers, pension funds, and other investors rather than banks, which tend to rely on deposits that can be withdrawn quickly in a crisis.
But new hazards are emerging as well. Alternative credit providers are less regulated than banks, and sometimes employ opaque structures that can obscure risk. They also increase competition between credit providers, potentially lowering lending standards as was the case in the run-up to the 2008-09 global financial crisis (GFC). And while new credit providers can add diversity and resiliency to the corporate credit market, the fact that banks are the biggest funders of these providers could reduce those benefits, and make the market vulnerable to a banking crisis.
Borrowers also need to be aware of potential risks. Chief financial officers (CFOs) must consider the increased complexity and interconnectedness in the credit market. As private credit expands, and corporate debt is packaged and sold to a broader base of investors, the original model of tight borrower-lender relationships may weaken — potentially reducing the possibility that lenders will be flexible in light of any deterioration in a borrower’s financial condition. Easy money is enticing, but companies want to be sure their lenders will be there when they need them — and that a borrowing boom doesn’t tank the economy and wreak wider havoc.
Ultimately, more opportunities are being created for business leaders to expand their funding options — but this also requires close monitoring from policymakers and regulators, to limit the chances of a future crisis.
Measuring the credit transformation
Alternative credit providers and products have been around for decades, but have only flourished recently. They typically offer higher yields than investment-grade debt securities, which made them especially attractive to investors in the low-rate environment of the post-crisis years. Banks, meanwhile, had their risk appetite reduced by higher capital and liquidity requirements and other restrictions imposed after the crisis.
As a result, once-niche areas of credit markets have boomed. Private credit, which is financing provided by private capital firms and business development companies, has expanded by a factor of four globally since 2013, while leveraged loans, which are extended to borrowers with large debt levels or poor credit histories, have nearly doubled.
The two segments now provide nearly 20% of US corporate credit, and the trend is spreading to other parts of the world; private credit has grown by 17% a year since 2018 in Europe (where it now represents 2% of corporate credit), and by 20% a year in Asia.
Monitoring the market
There are five key questions to consider when assessing the stability of today’s transformed corporate credit markets. Given that bank runs and margin calls can incite or exacerbate a financial crisis, policymakers, financial executives, and CFOs must ask themselves the following:
- What short-term liquidity promises are being made? It’s notable that US banks have extended $2 trillion in committed credit lines to nonbank financial institutions, with average utilization rates at about 50%. Private credit funds are also now offering lines of credit to corporations, but they have not yet been tested in a period of prolonged stress.
- How are financial chains evolving and are they becoming more leveraged? Large US hedge funds hold more than $800 billion in credit derivatives, for example, while private equity firms put nearly $70 billion of debt on their portfolio companies in the first three quarters of this year. Such layers of exposure and leverage, along with a lack of transparency, make it difficult to accurately assess the associated risks and may make the corporate credit market more fragile and vulnerable to a crisis.
- How large are traditional institutions’ exposures to corporate credit and nonbanks? Banks are expanding their direct exposure to corporate credit even as their market share declines. Simultaneously, they are increasing their indirect exposure by lending to nonbanks like hedge funds and private capital firms, which in turn draw in pension funds and other financial institutions. Private-capital-owned US life insurers now hold $600 billion in assets, representing 11% of the industry. Policymakers and executives need a comprehensive view of these interwoven exposures.
- How will novel high-quality assets perform in a crisis? Regulated financial entities have a need for such assets, which are often created through securitization — yet many of today’s products are untested by a crisis. Covenant-lite loans, which provide investors with fewer protections such as limiting the borrower’s ability to take on additional debt, now make up more than 90% of the leveraged loan market, up from just 1% in 2000. That suggests many CLOs may rest on shakier foundations than in the past. It’s also notable that one of the fastest-growing areas of the CLO market, amounting to more than $115 billion as of late 2023, invests in unrated private credit loans rather than leveraged loans. Policymakers need to monitor evolving standards to guard against excessive risk-taking, while CFOs must watch for signs of systemic risks that could contribute to a crisis and reduce their company’s access to credit.
- How might a crisis play out, and what entities will have the capacity and risk appetite to become buyers in a crisis? Nonbanks have become more critical for market liquidity, but they lack the support from central banks that banks enjoy. There are also questions about whether banks or nonbanks have greater incentives and means to provide credit support to corporations in a financial crisis, which is often when they need it most.
Policymakers need to understand the risk
Adapting regulation and supervision to these developments will take time, but policymakers should be vigilant for any signs of excessive buildup of risk. It is critical that executives and investors proactively enforce market discipline by demanding transparency on fund holdings and leverage, and the conducting of stress tests. Corporate CFOs, meanwhile, must carefully consider the tradeoffs when evaluating their options for financing.
The transformation of corporate credit markets can lower capital costs for companies while promoting financial stability, by relying on long-term funding from institutional investors. Yet the layers of leverage built on top of corporate credit could buckle when the current credit cycle turns down — potentially triggering a crisis and dramatically reducing the financing options available to corporations. Closer scrutiny now can preserve the benefits of the market’s transformation longer-term, and reduce the odds that today’s corporate credit boom sows the seeds for the next financial bust.
David Folsom, a Senior Analyst on the Oliver Wyman Forum’s Future of Money initiative, contributed to this article.