Emerging lessons from the current credit risk cycle

Experts discuss the challenges of higher inflation and interest rates, the impact on defaults, innovations in credit risk modelling and predictions for 2024

An extended period of high interest rates, coupled with inflation and weak growth, is increasingly impacting credit markets. In a recent Risk Live North America panel session, sponsored by S&P Global Market Intelligence, experts discussed the current credit risk cycle, exploring the impact of high inflation and interest hikes, along with default risk and the latest approaches to modelling. Here we reveal the main talking points from the session.

Observations on the current credit cycle

The panel found few reasons for optimism when considering the current credit cycle. Economic concerns are set against a backdrop of geopolitical risk that is continuing to pile pressure onto multiple sectors. Among the examples, commercial real estate challenges continue and there is also the potential ticking time bomb of student loan repayments, as the three-year pause in debt repayment comes to an end.

However, Chris Mann, lecturer at Columbia University and former head of wholesale credit risk modelling at Union Bank, outlined: “The real elephant in the room is interest rates. A lot of companies [in the US] cannot survive these higher-for-longer interest rates. Looking a little further at the medium to long term, states and local municipalities will also be unable to cope – high short-term interest rates on their long-term borrowings are coming at a time they are also struggling with higher expenses in other areas.”

Default risk by sector

Stewart Webster, director of credit and risk solutions at S&P Global Market Intelligence, provided analysis from S&P Global, which revealed the number of corporate defaults is currently at its highest level since 2009.

Examining the number of defaults by sector revealed that media and entertainment is leading the pack. While surprising, Webster explained: “This space is highly leveraged. Looking at the S&P Global ratings distribution chart for media and entertainment, more than 60% of those companies are rated B+ or lower.”

As for other sectors, more pressure is expected in homebuilders and real estate. Although S&P analysis showed fewer than half the number of defaults in 2023 compared to 2022, Webster cautioned the audience against optimism: “S&P Global research flags there are potentially six ‘fallen angels’ this year in the real estate space.”

In contrast, pivoting off geopolitical risks, the aerospace and defence, and oil and gas sectors are performing well. “For oil and gas, the theme has been rising stars, with 14 oil and gas companies having been upgraded this year. Only one has been downgraded,” noted Webster.

Current expected credit loss (CECL) models

Introduction of the CECL guidance has driven the formalisation of credit risk models in the US, requiring institutions to account for future economic conditions. This means credit risk teams have a range of econometric models at their disposal, underpinned by macroeconomic forecasts, to try to predict lifetime expected losses.

However, Steve Boras, executive vice‑president at Citizens Bank, pointed out that most of these models are unlikely to reference inflation as a key factor. “Inflation has not been a driver in the US for about 20 years. Now we have this spike in inflation, you want to be able to revert to these tools, but inflation is not in there,” he said.

However, on a positive note, Boras stressed that good models with good specifications will pick up inflationary effects via other elements, such as debt‑to‑Ebitda ratios.

Regional banking crisis

Ash Majid, managing director and chief risk officer at SMBC Capital Markets and SMBC Nikko America, explored the challenges of hedging events such as the regional banking crisis of spring 2023.

“The regional banking crisis was an idiosyncratic event. These are very hard to hedge if you are using macro- or basket-based hedges. Credit books that were long on the regionals probably went short on some of the super‑regionals or big-five banks. The correlational deterioration that happened in this instance is very challenging to predict.”

The panel agreed it is hard to overcome the lack of relevant data for correlational history. Developing appropriate tools to identify what hedges can be made and how baskets will behave during these crises is also very challenging. Leveraging artificial intelligence was identified as a potential solution to these problems.

Predictions for 2024

2024 will continue to see sector outperformance in the oil and gas, and aerospace and defence sectors, according to Webster. However, on a more cautionary note, he highlighted concern over speculative-grade companies: “Irrespective of whether or not there is a recession, there will be a repricing of credit and debt as maturities come up.

“A recent S&P report shows that, for entities with annual Ebitda of less than $50 million, the median interest coverage ratio is 0.6. A ratio of less than 1 means an entity cannot service its interest expense and, to put that number into perspective, for the entire spec-grade space, the median interest coverage ratio is 3.3. So there could be significant pressure in the middle-market space going forward.”

“This data means that half of those middle‑market firms are in substandard land,” highlighted Boras. “That puts certain limitations on their flexibility and, faced with maturity walls, it means they may not be in a position to amend and extend if their debt service coverage is below 1. This could potentially create a death spiral for those companies.”

In summary

There are many different headwinds affecting the current credit cycle. Market data reveals that the higher-for-longer interest rate environment and the maturity wall looming on the horizon are, increasingly, cause for concern. However, with so much volatility and different variables at play, it is incredibly difficult to predict the future. Operational resilience, along with developing and leveraging the right data, tools and technologies, are considered key to weathering the storm.
 

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