articles Ratings /ratings/en/research/articles/230309-credit-trends-risk-reshuffle-loans-could-become-riskier-while-bond-investors-may-be-too-optimistic-12653467 content esgSubNav
In This List

Credit Trends: Risk Reshuffle: Loans Could Become Riskier While Bond Investors May Be Too Optimistic


Credit FAQ: Adani Group: The Known Unknowns


Credit FAQ: Sharing Is Caring: U.K. Shared-Ownership RMBS Explained


Credit FAQ: What The "Two Sessions" Say About Chinese Government Finances


Credit FAQ: Why Most GCC Banks Can Manage Contagion Risk From SVB

Credit Trends: Risk Reshuffle: Loans Could Become Riskier While Bond Investors May Be Too Optimistic


Bonds Now Have Looser Financing Conditions Than Loans

The speculative-grade bond market came of age around the late 1980s or early 1990s. But within the last 20 years or so, leveraged loans have also been a popular funding vehicle for riskier issuers. Despite their difference (longer maturity lengths on average for bonds, floating rate structure for loans), the two asset classes have largely dealt with similar levels of credit risk on the underlying issuers, and as such, have generally had similarly priced spreads over the long-term (see chart 1).

During the peak of the global financial crisis, loans held much higher spreads, but in the time since, the two asset classes' spreads have remained tightly bound. Since 2017, loan spreads have consistently exceeded bond spreads by about 50 basis points (bps). However, since last May, loan spreads have widened by a much larger amount, averaging 183 bps wider per month than speculative-grade bond spreads. This is almost certainly a result of the rising interest rates prompted by the Federal Reserve last year in response to surging inflation, as underlying loan benchmark rates tended to increase alongside the rapidly rising Fed Funds rate. But given such similar credit risk, differing rate expectations may be widening the spreads gap recently.

Chart 1


Financing conditions, when measured by sentiment surveys of senior loan officers, indicate the gap between bonds and loans is wider still (see chart 2). The Federal Reserve's Senior Loan Officer Opinion Survey for lending conditions on commercial and industrial loans to large and medium-sized firms has historically trended alongside the speculative-grade spread. However, in recent quarters, the percentage of net tightening of terms and conditions on loans has been rising quickly, while the speculative-grade bond spread has remained low, or falling. For the most recent survey (covering fourth-quarter 2022), a major net share of banks reported tightening standards because of a less favorable or more uncertain economic outlook, as well as a reduced tolerance for risk.

Chart 2


During the pandemic in 2020, the reading on the survey shot up quickly to a near all-time high rate of 71, while the speculative-grade spread also rose, but to a much lesser extent, reaching 850 bps at its peak. Ultimately, our overall speculative-grade default rate reached 6.6% by year-end--much less than the Fed survey would have implied historically.

In primary markets, bonds have also gotten off to a stronger relative start in 2023 than leveraged loans (see chart 3). At $41 billion, the year-to-date speculative-grade bond total (through February) is comfortably above 2022, and roughly in line year-to-date totals in 2018 and 2019. This is a strong rebound from late 2022 monthly totals, which fell just short of $29 billion, and averaged $4.9 billion a month in the second half of the year. Meanwhile, leveraged loan issuance if off to a particularly slow start, reaching only $51 billion, consistent with the tighter financing in recent months amid rising rates. Year-over-year, this amounts to a 59% decline from the first two months of 2022.

Chart 3


But Bonds Now Have A Stronger Credit Profile Than Loans

Some of the relative increase in tightening conditions for loans could be attributed to their relatively weaker risk profile compared with bonds, particularly as their credit risk may be tested in the current rising-rate environment. Speculative-grade bonds have fallen in number in the last 13 years, but their rating distributions have been stronger(see chart 4). In 2010, roughly 45% of the 5,680 outstanding speculative-grade bonds in the U.S. were rated within the 'B' category. By mid-2011, this was a majority. However, by the end of 2022, there were 4,201 bonds outstanding, with only about one-third rated 'B'.

Chart 4


Conversely, in 2010, of the 1,638 outstanding speculative-grade loans, 41% were rated in the 'B' category. By the end of 2022, the number of outstanding loans reached 2,929 with 62% rated in the 'B' category. This is a marked shift of nearly 20% more 'B' loans, a clear majority of the total which has been on a nearly uninterrupted upward path.

In many ways, the distributions of bonds and loans in the U.S. have moved in completely opposite directions, with one both shrinking and strengthening, while the other has grown and weakened. A large factor behind the weakened loan distribution has been the influx of new issuers in recent years who have sought loan funding, with a majority carrying initial ratings in the 'B' category.

Chart 5


Bond Markets May Still Be Overly Optimistic

All things considered, a stronger rating distribution would certainly carry easier financing costs than a weaker one. But there are indications that current bond spreads may be too loose nonetheless. Comparably rated bonds and loans should have roughly the same level of spreads, or a consistent relationship. However, if looking at spreads for bonds and leveraged loans in the 'B' rating category, those also have a persistent historically large gap recently, with the three-year discounted loan spread averaging 190 bps above our five-year bond spread since September (see chart 6). This could imply bond markets are not pricing in enough risk for 'B' bonds, but one possible mitigating factor could also be that loans in this category carry shorter maturities and could thus be facing refinancing risk sooner than bonds of the same rating. That said, even during the COVID-19 period in 2020-2021, the two spreads largely tracked each other very tightly.

Chart 6


Additionally, our estimated speculative-grade bond spread has also been registering a consistently higher reading than the actual spread throughout 2022 (see chart 7). In January 2022, the estimated spread was 527 bps, compared to an actual spread of 372 bps. By January 2023, the estimated spread hit 643 bps, against an actual spread of 382 bps, for a gap of 260 bps. Broad financial market volatility has been elevated throughout 2022, while economic activity has been slowing. It is arguable that the speculative-grade spread has remained unusually low within this backdrop.

Chart 7


Historical Rating Trends May Be Challenged

Despite financing indicators that have trended historically close for the last few decades, default rates for speculative-grade bonds and loans have not necessarily moved in lock-step (see chart 8). While both bonds and loans tend to have major default cycles overlap, peak default rates for bonds tend to be much higher, and bonds also undergo more defaults between major cycles. This is in part attributable to the large share of distressed exchanges and other selective defaults which typically occur far more often among bonds. During the 2014-2016 period of higher bond defaults, this was also in part because of the concentrated nature of defaults during that period among oil and gas companies, an industry that tends to rely more on bond financing.

Chart 8


But, in the period from 2020-onward, defaults for bonds and loans have generally moved together tightly and are both currently very low (1.9% for loans in the 12-months ending January, 1.15% for bonds). We expect defaults to pick up this year in the U.S. and globally as economies slow down, and rates remain elevated, cutting into cash flow. Given rising interest costs are a near-term stressor for loans and that loans have a demonstrably higher risk profile relative to bonds, we may see the default rate for loans keep pace with or exceed that for bonds in the months ahead.

A good indicator of relative default risk is the proportion of ratings in the 'CCC/C' category, as well as any increased pace of downgrades, which can tend to lead defaults given those ratings' high likelihood of default, and little room remaining if rating downgrade momentum picks up. At the end of 2022, 12.9% of speculative-grade bonds in the U.S. were rated 'CCC/C', while 17% of loans were indicating slightly higher near-term credit risk among loans. In terms of momentum, both bonds and loans see an uptick in downgrades into the 'CCC/C' category (see chart 9). For now though, both asset classes have similar 'B' downgrade rates of 5.5%, and 5.4%, for loans and bonds, respectively.

Chart 9


While overall credit deterioration into the lowest ratings has been fairly stable and running parallel between speculative-grade bonds and loans recently, there appears much more risk concentration among loans at a sector level (see chart 10). When looking at the sector-level breakout of loans rated 'B-' and lower, the top five sectors (or 13) account for nearly 90% of the total. Conversely, these same sectors account for slightly less than 70% of the total among outstanding bonds.

While these sectoral breakouts are rather large in their reach, there is a focus--particularly among loans--on the consumer (leisure time, media; and consumer service), as well as representation from sectors who in recent years have had quick and large growth in their number of new loan issuers with a 'B' or 'B-' rating (high tech; and healthcare). Depending on how the expected economic slowdown plays out, as well as how high and for how long the Fed will raise interest rates, the relative concentration of 'B-' and lower loans could amplify (or suppress) a potential difference in the magnitude of default rates between bonds and loans ahead.

Chart 10


Whether speculative-grade bonds or loans see similar or divergent default rates in the months ahead is an open question. Both face unique challenges: loans are being stressed via the constant wear and tear of rising rates, which make ongoing interest payments greater, and bonds could face "sticker shock" from higher rates when they need to be refinanced. For now, it seems loan markets are facing higher rates directly, as floating-rate benchmarks such as LIBOR, SOFR, and Euribor rise alongside central bank hikes. And the amount of outstanding loan debt rated 'B-' and lower is large: $583 billion. Meanwhile, the amount of riskier bonds coming due in the near-term is relatively small – about $21 billion rated 'B-' or lower, due through 2024. This will limit refinancing risk in the near-term for bonds.

But bond investors appear to be holding out more hope that their longer-dated debt can ride out long enough to last until the Fed pivots. That could prove risky as the signals for inflation ahead, and the path for the Fed both become less clear. More recently, it has become more likely that interest rates will ultimately reach higher levels than previously expected. We also estimate that coupon rates by rating category on maturing bonds over the course of the next year or so are, on average, about 2% lower than current primary market rates, so when bond issuers need to refinance, their costs of debt will certainly increase. And this could be an understated figure given the high proportion of downgrades since the pandemic began in 2020.

Related Research

This report does not constitute a rating action.

Credit Research & Insights:Nick W Kraemer, FRM, New York + 1 (212) 438 1698;

No content (including ratings, credit-related analyses and data, valuations, model, software, or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced, or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees, or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness, or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.

Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment, and experience of the user, its management, employees, advisors, and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.

To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.

S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process.

S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, (free of charge), and (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at