Bank of England warns of private credit vulnerability in higher rates environment

In its Financial Stability report published today (6 December), the central bank said the adjustment to higher interest rates continues to make it more challenging for households and businesses in advanced economies to service their debts.

The BoE said that riskier corporate borrowing in financial markets, such as private credit and leveraged lending markets, which have roughly doubled in size in the last decade, “appear particularly vulnerable”.

Businesses that have borrowed in these markets face greater risk of default given that their debt tends to be floating rate and because they tend to be highly leveraged, the Bank noted.

Central bank body warns hedge fund bets risk dislocating US Treasury market

“Although there are few signs of stress in these markets so far, a worsening macroeconomic outlook, for example, could cause sharp revaluations of credit risk,” it added. 

If losses from defaults to lenders and other financial market participants are significant, the BoE said this could cause “excessive tightening” in risk appetite, which could disrupt the functioning of some markets and tighten credit conditions in the real economy.

“Should growth weaken or other risks crystallise, a reduction in investor risk appetite could trigger a revaluation of assets, particularly since a deterioration in demand or corporate earnings would negatively impact debt servicing capacity,” it said.

The opacity and the lack of frequent re-pricing of private credit assets increases their vulnerability to sharp and correlated falls in value, the report noted.

Global financial watchdog issues stark warning over further shocks – reports

In its report, the central bank said that while the financial system has so far been “broadly resilient” to the higher interest rate environment, vulnerabilities in market-based finance remain “significant”, and in some sectors have increased since the last financial stability review.

Since the July review, hedge funds’ net short positioning in US Treasury futures had increased from around $650bn to around $800bn, now exceeding in nominal terms its size prior to the 2020 “dash for cash” market stress, as asset manager net long positions have continued to grow.

“Hedge fund net short positioning and asset managers’ leveraged net long positions in US Treasury futures have also increased further, which could contribute to market volatility if hedge funds needed to unwind their positions rapidly,” the Bank said. 

Bank of England warns higher rates could lead to corporate defaults

The Bank of England is not the first to raise awareness of the risks created by the build-up of hedge fund bets in the US Treasury market.

In September, the Bank for International Settlements issued a warning about the growth of ‘basis trade’, a hedge fund strategy in which investors attempt to profit from small price discrepancies between Treasury bonds and their futures market equivalents.

In August, the Federal Reserve also reported a surge in the amount of hedge fund basis trades executed and warned about the dangers such a build-up presented to financial stability.