Companies needing to raise money have had a tough time doing so in 2022. Companies with bad credit or too much debt found out this tough fact the hard way. After over a decade of low-interest rates and easy-lending conditions, companies with poor credit ratings are essentially getting shut out of lending markets. Why?

Rising interest rates and geopolitical tensions have contributed to volatility across all assets, including debt markets. As a result, fewer investors are interested in lending to low-quality companies amid economic uncertainty.

Let's take a closer look at how this new mindset impacts borrowers and lenders and what investors should watch for next.

Banks took a sizable loss on this type of loan

Last month, a group of banks, including Bank of America (BAC 0.92%), Credit Suisse (CS), and Goldman Sachs (GS 0.15%), helped finance the leveraged buyout of Citrix Systems by private equity firms Vista Equity Partners and Elliott Investment Management. The banks helped finance half of the buyout debt, which was $8.55 billion. 

Private companies will often use debt to fund a leveraged buyout of companies. This debt sits on the acquired company's balance sheet and tends to be junk-rated debt, which helps juice the private equity firm's returns. Banks prefer to work together to make loans for riskier borrowers to spread out the risks, and they are popular to use in leveraged buyouts like Citrix.

Loans made to high-risk borrowers with a lot of debt or a poor credit rating are called leveraged loans. These loans earn higher interest in return for their higher risk. Banks don't want to hold these loans long-term because they don't like the added leverage on their books. They also face strict regulatory requirements and often recycle their capital to meet them. That includes offloading these higher-risk leveraged loans, which other institutions buy. 

When the banks went to sell the Citrix loans, there was little demand from investors. When all was said and done, Bank of America, Credit Suisse, and Goldman Sachs took a combined loss of $700 million to get these loans off their books. 

News of this loss spread and it has affected other efforts to secure financing. Recently, a group of banks canceled their effort to sell $3.9 billion in debt that would finance Appollo Global Management's purchase of Lumen Technologies' telecom and broadband assets. 

Major banks are mostly avoiding leveraged loans

In the third quarter, Citigroup (C 0.05%) announced it took a $110 million write-down on its leveraged loans. Other banks have pulled back from leveraged loans altogether this year. JPMorgan Chase (JPM 0.50%) has remained on the sidelines of this financing market for most of the year, and Morgan Stanley (MS 0.81%) has scaled back its leverage exposure during Q3. 

The pullback in lending makes it difficult for private equity firms to close buyouts of companies, with Kevin Sterling, global co-head of private credit at Goldman Sachs, saying, "there's no doubt that the cost of capital has gone up materially for debt financing of private equity transactions over the past 6-9 months." 

Stressed person rubs their eyes while sitting in front of their laptop.

Image source: Getty Images.

The lending pullback is hurting a whole class of companies

Leveraged loans were a popular investment among institutional investors looking for yield in a low-interest rate environment. However, the Federal Reserve is aggressively raising interest rates, making safer investments like U.S. Treasuries attractive to yield-seeking investors.

The real risk in the pullback of these loans is those companies that rely on them. Companies that use leveraged loans are on weaker financial footing. These loans can help finance merger and acquisition deals, refinance existing debt, recapitalize the balance sheet by injecting cash, or for other general corporate purchases. Without access to this financing, companies could find it challenging to raise funds when they need it the most, which could lead to an uptick in defaults.

Earlier this year, Cineworld and Phoenix Services filed for bankruptcy, bringing the leveraged-loan default rate in the Morningstar LSTA US Leveraged Loan Index to 0.90%. This is still far below the pre-pandemic trend of 2% but up from April when defaults hit a record low of 0.26%.

According to UBS Group, default rates on leveraged loans could reach 9% if the Fed continues its aggressive interest rate policy. Banks avoided these loans, so the immediate risk is on companies with high debt burdens or lower credit quality. However, if UBS is right and defaults skyrocket, institutions holding these loans and banks will undoubtedly feel some of the ripple effects.