The Transformation Of Corporate Credit

The corporate credit market is undergoing its biggest transformation since large companies started turning to the bond market instead of banks for financing in the 1980s. Private capital firms are gaining market share from banks through direct lending and products like collateralized loan obligations (CLOs), while hedge funds are making a splash in leveraged loans and corporate bonds. An explosion of fixed-income exchange-traded funds (ETFs) is helping retail investors get exposure to the bond market and enhancing liquidity.

These and related innovations are improving credit availability by expanding the options for borrowers and investors, which can foster more business investment, hiring, and economic growth, according to Rewiring The Financing Machine, a new report from the Oliver Wyman Forum. The innovations, which are most advanced in the United States but spreading to Europe and Asia, also reduce some risks by relying 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capital from insurers, pension funds, and other investors rather than banks, which tend to rely on deposits that can be withdrawn quickly in a crisis.

 

Yet the new corporate credit model carries hazards as well as benefits. Alternative credit providers are less regulated than banks and sometimes employ opaque structures, which can obscure risk. They also are increasing competition between credit providers, potentially leading to a lowering of standards, which can cause problems. 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 undermine those benefits and leave the market vulnerable to a shock like the 2008-2009 global financial crisis.

Policymakers and industry executives need to better understand and monitor the risks and interconnections of the new corporate credit model to reduce the chance of a future crisis.

Measuring the credit transformation

Alternative credit providers and products have been around for decades but flourished in the wake of the global financial crisis. They typically offer higher yields than investment-grade debt securities, making 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 2008.

As a result, once-niche areas of the 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 debts or poor credit histories, have nearly doubled. The two segments now provide nearly 20% of US corporate credit. 

This 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 risks

There are five key questions to consider in 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 and financial executives must ask themselves: What short-term liquidity promises are being made? It’s notable that US banks have extended $2 trillion in committed credit lines to nonbanks, with average utilization rates at about 50%.

Next, 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. 

How large are traditional institutions’ exposures to corporate credit and nonbanks? Banks have lost market share in corporate credit, but they are major lenders to nonbanks. US life insurers owned fully or partly by private capital firms have $600 billion in assets under management, representing 11% of the US life insurance industry. Policymakers and executives need to take a comprehensive view of all these avenues of exposure. 

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, but the process can generate products with different claims on corporate assets and pit the interests of senior debt holders against junior debt holders. Some of these structures are untested. For instance, one of the fastest-growing areas of the CLO market, reaching more than $115 billion in late 2023, invests in unrated private credit loans rather than leveraged loans. 

Finally, 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 channels 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 firms in a prolonged crisis. 

Adapting regulation and supervision will take time, but policymakers should be vigilant for any signs of excessive buildup of risk. It is also critical that executives and investors proactively enforce market discipline by demanding transparency into fund holdings and leverage and conducting stress tests. 

Closer scrutiny now can preserve the benefits of the market’s transformation and reduce the odds that today’s corporate credit boom lays the seeds for the next financial crisis.