The financial sector encompasses banks, insurance companies, investment firms, and other financial institutions, and has both direct and indirect impacts on the markets. The industry has undergone significant transformation in recent years, with the rise of digital advancements and financial technology. High-tech solutions to support financial literacy, biometric security systems, autonomous finance, open banking, digital-only banks, voice technologies, and more are among the top trends in the financial services industry.
However, any weakness in the financial sector could have a domino effect on the markets, especially the technology sector. According to Eric Rosenthal, Senior Director of Leveraged Finance at FitchRatings, the leveraged loan universe is worth $1.68 trillion, and high-yield bonds are at $1.33 trillion, both essentially unchanged from year-end 2022. This over $3 trillion market has grown 100% since the 2007-2009 financial crisis, with the leveraged loan market alone growing by about 130%.
Leverage loans with high inflation rates present a direct threat to rising default rates, particularly for the technology and healthcare/pharmaceutical sectors, which are the largest in amount outstanding of leveraged loans. Rising default rates are not only important for financial institutions such as banks and insurance companies, which must increase their capital to prepare for unexpected losses, but they also make investors nervous, increasing market risk exposure for financial institutions and adversely impacting asset prices.
According to PwC's Capital Markets Annual Outlook 2023 report, US debt capital markets raised $1.7 trillion in 2022, down from $2.6 trillion in 2021. The leveraged finance markets faced significant challenges in 2022, with a number of leveraged buyout (LBO) transactions in which banks were unable to sell debt to investors, resulting in a 47% decline in high-yield bonds and leveraged loans. This decline could cause increased leverage of capital.
Given the current market nervousness about banks' financial health, there is a concern that if banks tighten credit to corporations, default rates could rise. Almost all kinds of investors, including banks, insurance companies, pension funds, hedge funds, asset managers, and wealth funds, hold leveraged finance instruments in their portfolios. Tightening credit could cause these investors to limit their holdings, causing sell pressure in the markets.
In this environment of high inflation and uncertainty about the banking sector's financial health, market participants should scrutinize US leveraged finance markets carefully. Investors should monitor corporate bond yields, as they signal investors' perceptions about default probabilities and expectations of loss severity. The rescues of Silicon Valley Bank, Signature Bank, and Credit Suisse have increased the spread between corporate bond and treasury yields, signaling investors' risk aversion.
In conclusion, while the financial sector has undergone significant transformation in recent years, it also presents potential risks to the markets, particularly the technology sector. Investors should monitor the leveraged finance markets carefully and pay close attention to corporate bond yields to assess the risk of default and potential market impacts.