Here's Why Now Isn't the Best Time to Take Out a Loan

The credit market has seen better days...

Interest rates are rising. Credit continues to tighten. Financing isn't as accessible as it used to be.

Just look at the state of the high-yield ("junk") bond market. These bonds are viewed as much riskier than their investment-grade counterparts, because the underlying companies are more likely to default. So they have higher yields as a result.

Defaults in the $1.4 trillion U.S. junk bond market have risen substantially this year. The Federal Reserve's aggressive rate hikes are putting pressure on riskier companies.

According to Goldman Sachs, there were 18 debt defaults from January to May totaling $21 billion. That value is more than 2021 and 2022 combined.

Weak companies with large debt piles are taking the biggest hit. The scary part is... the Fed anticipates two more hikes this year. So what we've seen so far is likely only the beginning.

Companies in need of refinancing will keep running into issues... Their risk of default will rise. Today, we'll take a closer look at why this is a bad time for risky businesses to be in trouble.

It's not just bond markets that are closed to borrowers...

Banks aren't exactly rushing to hand out loans, either.

John McClain, a portfolio manager at Brandywine Global Investment Management, said in June that "the credit quality of the loan space is poorer than the bond space."

This reduced access to credit is putting companies at higher risk of default, since they can't refinance. That's why some companies that have previously defaulted, including Envision Healthcare and mattress retailer Serta Simmons, did so again this year.

Banks are tightening lending standards at rapid rates. We can see this by revisiting one of our favorite ways to track credit standards – the Senior Loan Officer Opinion Survey ("SLOOS").

The SLOOS is a quarterly survey performed by the Federal Reserve. It asks loan officers if their lending rules have tightened, eased, or remained unchanged in the past three months.

In other words, it indicates how eager banks are to provide loans... and how simple or difficult it is for firms and individuals to access credit.

The chart below shows the percentage of domestic banks that tightened standards for commercial and industrial (C&I) loans to large- and middle-market firms. As you can see, banks are still tightening faster than in any time since 1990... other than the past four recessions.

Take a look...

Banks understand that consumers and corporations are under a lot of financial strain. They're choosing to not hand out money to them as a result.

Companies are built on the backbone of loans and debt...

That's why understanding credit availability is key for investors. If a company's loans are worthless, its equity will be worthless, too. You need to know where these companies are positioned at all times.

Watch out for companies with large exposure to debt that they can't refinance. Some have variable-rate debt that gets more expensive as interest rates rise. So when lending standards tighten and they can't come up with the money, they're at risk of defaulting.

Banks are being strategic with capital deployment and investments. Given the current market conditions, this seems like a smart move.

We still think we're looking at a more or less sideways market for the rest of the year. If credit conditions take a nosedive, our forecast could become even more bearish.

Regards,

Joel Litman
July 24, 2023