US Non-Bank Credit Market Faces Dual Threat from Defaults and Rising Interest Rates
The U.S. non-bank credit market, which has provided the majority of loans to medium-sized companies over the past decade, is currently under pressure from two fronts simultaneously. Default rates in this market have climbed to a record 6.1% in the 12 months ending in July, significantly higher than the historical average of 2% to 2.5%. Concurrently, high oil prices are prompting the Federal Reserve to consider further interest rate hikes.
Recent market data illustrates this challenging environment. U.S. oil prices hovered around $99 a barrel, while Brent crude traded near $103.60. The yield on 10-year U.S. Treasury bonds rose by over 11 basis points to approximately 4.95% in the latest trading session. The market is now pricing in a nearly 70% probability of an interest rate increase at the Federal Reserve's September 15-16 meeting.
The combination of these factors is particularly perilous due to the structure of loans in this market. Direct loans in the private credit market typically carry variable interest rates, pegged to the U.S. SOFR rate. Any central bank rate hike is quickly passed on to borrowers' payments within weeks, with no grace period or option to lock in previous terms. This creates a double blow for leveraged companies: rising inflation driven by energy costs increases expenses for raw materials, transportation, and wages, eroding operating profits, while simultaneously, the cost of servicing debt escalates.
The primary risk in this market is inflation, more so than the interest rate level itself. An interest rate hike triggered by soaring energy prices negatively impacts both sides of a company's financial equation. The true test lies in the interest coverage ratio. Companies with operating profits two to three times higher than their financing costs can absorb further rate increases. However, those with a ratio close to one risk having their entire operating profit go to lenders, leading quickly to debt restructuring.
A significant portion of loans in this market originated in 2020 and 2021, during a period of near-zero interest rates, and are now maturing. The expectation is that this process will unfold gradually rather than as a single event. Stronger borrowers may refinance under new terms, while struggling borrowers might receive extensions, amended agreements, capital injections from shareholders, or debt settlements. The rise in default rates and loans no longer accruing interest indicates this process has already begun.
For lenders, the situation is mixed. In the short term, rising interest rates increase current portfolio yields due to the prevalence of variable rates. However, some of this gain is offset by credit losses if marginal borrowers default. The longer rates remain elevated, the greater the chance of these losses becoming significant. On a more positive note, considerable adjustment has already occurred. New loans are being issued with stricter underwriting standards, many companies have extended maturity dates and received lender support, and without a severe recession, the wave of defaults is expected to be manageable compared to past cycles. It is estimated that a further increase of 50 to 100 basis points or more in yields on lower-quality debt would be needed to trigger a widespread problem.
What has changed recently is the underlying assumption. For two years, many in the market, both borrowers and lenders, operated under the belief that interest rates would decline after peaking in 2023 and 2024. The current rise in yields invalidates this assumption, shifting the focus from when borrowing costs will decrease to whether companies can sustain current debt costs through profit growth, deleveraging, or additional capital raising.
For Israelis, this situation has a more direct impact than might be apparent. Institutional investors have increased their exposure to illiquid credit and other non-marketable assets in recent years. The valuation of these assets is updated infrequently and with a lag, meaning a seemingly stable portfolio in quarterly reports might not be as stable as it appears, simply because it is measured less often. Ultimately, the same chain reaction is driving the entire market: oil drives inflation, inflation brings interest rates back into play, rates translate into bond yields and rising debt costs, impacting leveraged borrowers with no financial cushion.
