Debt Markets Are Making Wall Street Nervous With Their ‘Star Wars Garbage Chute Situation’

It’s a good time to sell corporate debt, but many experts are starting to wonder if the time is too good. Private credit, a newer phenomenon that does have 2008 vibes and origins, has emerged as a big trillion-dollar player in debt markets, and the rising defaults in this relatively new and opaque industry are becoming more worrisome by the day. Earlier this month, Bank of America said private credit is facing “clear signs” of rising stress as it found that realized losses across business development companies were at “the highest dollar value since the pandemic,” which “suggest[s] portfolio companies continue to struggle with interest costs.”

In addition to the losses over $1 billion taken in just the second quarter alone, these firms are carrying an additional $1.3 billion in unrealized losses. They made various loans in 2021 when ZIRP was the law of the land and debt was free, and now inflation is at 3 percent and the Fed Funds Rate is at 4 percent, and all those loans issued near 0 percent are in bad shape compared to current market value. Should these firms become forced sellers before the debt matures, those loans would be heavy losses to take.

You can see the broader concern in this narrowing garbage chute debt market situation in the spread between corporate bonds and Treasury Bonds. Since Treasurys are considered “risk-free” (at least until Trump’s 19th century economic policy becomes fully realized), however much you pay above them represents the risk you are taking. The fundamental law of finance is that you should be compensated for any kind of risk you take on, and the more risk, the more money you should get. The problem is that the current spread between investment-grade corporate bonds and Treasurys is at its lowest level since 1998. The spread between Treasurys and junk-rated bonds is near the record low set in 2007, a year we all know and love as one that hearkened great things for our economy. According to these very important spreads, Bank of America is just a bunch of debbie downers and there’s nothing to worry about in corporate credit and default risk is near all-time lows.

If the risk was proportionally low to those spreads right now, they would not be a problem. It would simply be descriptive of the safe environment for loaning companies money, but with the economy slowing and private credit defaults rising as its trillion-dollar tentacles are a bit of a mystery to where they go outside of wealthy people and the biggest players like BlackRock, most experts speaking to the press on this subject believe that there are many risks the market is not pricing into account, especially in light of Tricolor Holdings’ recent rapid default. Some worry they are a canary in the debt market coal mine, while others claim their failures were due to idiosyncratic reasons. They had amassed $2 billion in asset-backed bonds over the last five years, some of which were trading for as little as 20 cents once it filed for bankruptcy after its business of supplying auto loans to low-income buyers without a credit history went belly up.

Debt Markets Are Making Wall Street Nervous With Their ‘Star Wars Garbage Chute Situation’

When it’s stock market risks people don’t see, it’s a little less worrisome since that market has turned more into gambling anyway and those losses can be stomached. Stock markets have long been able to stay irrational longer than bears like me can stay solvent, but debt markets are where the globe’s adults are supposed to reside. Debt losses compound themselves, as companies take debt out and issue bonds in order to finance spending elsewhere. If a debt deal blows up, all of a sudden you have to use cash you allocated somewhere else to plug the hole you just blew in the ship, and if you still have debt payments to make, the situation can get very dire very fast. If a lot of debt deals blow up at the same time, well, string enough of them together and you’ll get why 2007 is not a year that portends greatness for the economy.

Also giving smart money the heebie jeebies is that Bank of America found that debt maturity walls are at historic highs as well, as 17 percent of private credit deals are coming due in the next two years. U.S. middle-market issuers are going to need $170 billion of capital over that period to pay this bill, but for now, that is not as big of a concern because BofA also found that $160 billion in dry powder is marked for domestic direct lending strategies. Unless, a hole gets blown in the ship and that money has to be used elsewhere. Then this can become a serious problem that could trigger a wave of defaults the next two years.

All the above plus the slowing economy and stubborn inflation combined to make high-yield bond analysts at Barclays compare the current situation to the famed Star Wars garbage chute scene, with “the walls compressing on all sides.” Historically, most loan losses happen because of the broader economy, and the conditions in those markets when the economy goes dictates a lot of how the debt bomb will unfold as the economy declines. We can’t just sit here with everything spiraling in the direction it’s headed, because eventually, it will all squish us like a bug. Something must change. Ideally, extreme economic growth without the inflationary effects alongside it.

A very simple rule of any credit boom is the longer it lasts, the likelier it is that defaults will rise, which is happening in private credit as we speak. The market is currently not priced for adequate risk, per risk managers across the debt market spectrum, and with both stocks and corporate bonds’ valuations soaring, the more susceptible they become to selloffs as people naturally just take profit. The combination of rising defaults and market selloffs can create something of a negative feedback loop, and this is absolutely not the kind of snowball you want to get rolling downhill.

Lowering interest rates will help abate some of the interest rate-driven pressure all these private creditors are feeling right now and alarming BofA analysts, but unless Trump really does make himself Fed Chair, we are not going back to 2020-21 era interest rates. Loans made during that era are going to be underwater until they mature, and unrealized losses are not that big of a problem, right up until you have to realize them, so the fear is rising that private credit defaults may eventually force that catastrophe on other lenders tied to them. The problem with any interest rate sensitive business right now is that Trump’s tariffs are having inflationary effects and so interest rate relief is not as straightforward as it seems, and the economic growth people want can also make inflation rise and create more pressure on these debt markets roiled by higher interest rates. The garbage chute analogy is apt because it’s difficult to improve one aspect of the increasingly tenuous financial situation in debt markets without deteriorating another. We are kind of stuck to a degree in a stagflationary dynamic that will not unfold favorably over the long term.

“I don’t get it, why everything is [holding up] this well. It’s odd,” said Joe Auth, head of developed fixed-income markets at fund manager GMO to The Wall Street Journal about the frothy corporate debt markets. We are in a strange world where the stock market needs expansive economic growth to justify the valuation it has already priced into itself through gargantuan amounts of AI capex spending, while higher interest rates are forcing a lot of struggling borrowers and lenders into and towards default, yet the highest-grade debt is going bonkers. The total risk profile in debt markets doesn’t add up to what credit spreads are calculating, and the fear is not necessarily what we are seeing in this narrowing garbage chute of private and corporate debt, but what we aren’t seeing.