Tighter Bank Lending Standards Could Mean Higher Risks for High Yield Companies

Wednesday, February 8, 2023

The Federal Reserve (Fed) released its quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices” report this week 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 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, it could mean higher yields and spreads for the high yield index (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.

View enlarged chart

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. Markets are currently pricing in a 3–4% default rate over the next 12 months, which is in line with historical averages and a fair estimate in our view. However, given the ongoing economic uncertainty and, frankly, potential for geopolitical risks, defaults could be higher than what is priced in (of course defaults could be lower if the Fed is able to engineer a soft or soft-ish landing). High yield spreads are currently trading below historical averages, so we think the asset class is rich given the aforementioned uncertainties. While we like high yield from a strategic perspective (for investors with a longer-term time horizon), we would caution investors interested in allocating new assets to the space, as there will likely be increased volatility in the near term.



This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Tracking #1-05359646