Rising interest rates may make fixed income look more attractive, but financial industry experts are sounding alarms for a potential credit crunch. They say that real concerns are starting to emerge in commercial real estate lending, mortgage-backed securities and collateralised loan obligations.
For fixed income analysts and investors who need to be able to navigate this challenging environment, having the right independent evaluated pricing and fixed income models are essential.
- Pandemic fallout and rising interest rates could potentially lead to increased defaults in several fixed income asset classes, according to analysts and investors.
- Commercial real estate lending, mortgage-backed securities and collateralised loan obligations could see a decline in credit quality over next two or three years, experts say.
- Using high quality independent evaluated pricing and fixed income analytics to perform scenario analysis and stress testing is essential to managing potential credit risk.
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The 2020s are proving to be a tumultuous decade, economically speaking – and this may soon morph into a credit crunch, according to some analysts, investors and other experts. A surge in inflation due to loose monetary policy during the Covid-19 pandemic and the conflict in the Ukraine is resulting in interest rate hikes around the globe. These are designed to tighten the availability of credit – and the experts say that the policy is having this impact. However, higher interest rates have also historically sparked recessions and increases in the number of defaults on fixed income, loans, and other credit instruments.
The failures of Silvergate Bank, Signature Bank, Silicon Valley Bank, First Republic, and the sale of Credit Suisse to rival UBS are giving analysts and investors the jitters about the shape of a credit crunch that they say will emerge over the next 24 to 36 months. Three credit-based asset classes are currently in the spotlight – commercial real estate (CRE) lending, mortgage-backed securities (MBS) and collateralised loan obligations (CLOs). Let’s take a look at each in turn.
Is the CRE cycle turning?
In the US, CRE lending was dealt a one-two punch over the past three years. Companies and their employees have decided that home working is here to stay in many office-based sectors, so demand for office space is much softer than anticipated. In addition, more consumer spending has shifted from retail locations to the internet. Both trends are resulting in lower demand for commercial real estate.
So, the rise in interest rates is hitting CRE lending hard. In July 2023, almost $12 billion of loans in US commercial mortgage-backed securities (CMBS) became newly delinquent. This increased the late payment rate by 34 basis points from June to 3.93%, according to credit rating agency KBRA. In July 2023, both JPMorgan Chase and Wells Fargo said that they have set aside more cash for expected losses from CRE loans.
Refinancing CRE loans is also expected to get tougher. Banks hold 54% of the overall $5.7 trillion US CRE market, with small lenders holding 70% of CRE loans, according to Citigroup analysts. More than $1.4 trillion in US CRE loans will mature by 2027, with $270 billion coming due this year, according to real estate data provider Trepp. To try and prevent accelerating defaults, US CRE lenders are already changing terms and conditions on loans.
Are MBS markets slowing?
Analysts and investors say the MBS market is also starting to wobble – creating flashbacks for those who experienced the rolling implosion of the MBS market during the Financial Crisis of 2008.
According to Refinitiv data, global MBS issuance fell to a 23-year low in the first four months of 2023 – it was just $100 billion, the lowest since 2000. This is the direct result of higher mortgage rates impacting property sales and refinancing.
Compounding these difficulties in the $11 trillion US MBS market is the uncertainty about how the US federal government is going to sell the $91 billion portfolio of MBS it took on during the collapses of Silicon Valley Bank and Signature Bank. Indeed, the decline in the value of Silicon Valley Bank’s enormous MBS portfolio – as a result of interest rate rises – helped to kick off the March 2023 bank run.
Will CLOs see increasing defaults?
US CLO issuance surged during the Covid-19 pandemic, reaching a record high of $183 billion in 2021 thanks to very low interest rates. Until now, CLOs – packages of generally low-grade corporate loans – have seemed to be resilient. They raised a further $126 billion in 2022 — the third highest annual figure ever, according to Refinitiv data. However, according to data from JP Morgan, issuance of CLOs is slowing. Nearly $69 billion worth were launched or refinanced during the first half of 2023, which is a 41% decrease compared with the same period in 2022.
Demand for new issues is lower because investor worries about the asset class are on the rise. While default levels are low now, they are increasing. According to Reuters, the restructuring at French retailer Casino and the bankruptcy of US retailer Bed Bath & Beyond “exposed cracks in business models that were previously insulated by abundant money supply and low rates”. S&P Global estimates that more than one in 25 US companies and nearly one in 25 European businesses will default by March 2024 – which will significantly push up the CLO default rate.
Credit rating downgrades of the companies that have loans in CLOs might make things much worse. That’s because CLOs have limits on the amount of low-grade debt they can hold. Exceeding the threshold results in a shift in the way payments are allocated to investors, potentially reducing demand for new CLOs – especially by investors who normally take the riskiest elements on. Unfortunately, the demand for refinancing will come just at the time when the pandemic surge in lending comes due.
Looking towards the future
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