Fed’s Relentless Hikes Bring Higher Corporate Default Risk
Some strategists, money managers say risk is underappreciated
Fed will likely allow defaults to move higher for longer: JPM
By Olivia Raimonde, Jill R. Shah and Josyana Joshua
9/21/22
As the Federal Reserve gears up to hike rates again on Wednesday, some strategists think that credit markets are too cavalier about how monetary tightening will trigger corporate defaults and hurt junk bonds and leveraged loans.
The Fed has already lifted rates by 2.25 percentage points this year, as central banks globally try to get inflation under control. That boosts expenses for high-yield companies while potentially cutting into revenue. And the hiking already appears to be having an impact on weaker corporations, with six U.S.-based borrowers tracked by S&P
Global Ratings having defaulted last month, representing a quarter of the total for 2022.
The pressure from rising interest rates may result in the corporate default rate rising to 5% or 6% by the first half of next year, UBS Group AG strategists led by Matt Mish wrote at the end of August, from around 1.5% last month. But the US junk bond market seems relatively unconcerned: risk premiums on the notes are averaging 4.83 percentage points, below the 20-year mean of 5.1 percentage points. In times of real market stress, spreads are usually closer to 7 percentage points or more.
The economy can veer into recession faster than many investors seem to be recognizing now, said KC Baer, a cofounder at credit-focused hedge fund CKC Capital, which is focusing on shorter-term bonds now that have less default risk.
“If the economy quickly enters a downturn, companies with liquidity challenges may have to get creative to avoid problems,” Baer said. “A severe and prolonged downturn changes default calculations and could easily put pressure on parts of the market that are currently considered safe.”
Federal Reserve officials have been adamant that their highest priority is bringing inflation under control even if that weighs on the economy. Fed Vice Chair Lael Brainard earlier this month said the US central bank will have to raise interest rates to “restrictive” levels, where they will remain for “some time.” Last month Fed Chair Jerome Powell said restoring price stability will require a sustained period of below-trend growth, and will bring “some pain to
households and businesses.”
Michael Feroli, an economist for JPMorgan Chase & Co., said rising defaults may result. But after years of tighter regulation on the financial system, banks and other institutions can likely withstand the pressure, Feroli said.
“They believe that the financial system and financial institutions are better insulated than they were in 2007,” he said. “So the high levels of capital should protect financial institutions from being an amplification mechanism for economic weakness in the face of rising defaults.”
It’s small- and medium-sized firms that will likely experience the pressure first, especially as banks and direct lenders ration financing, according to Ed Altman, creator of the Z-score for predicting insolvencies and professor emeritus at New York University’s Stern School of Business.
“I see some indications of cash flows and earnings of middle-market companies slowing down quite a bit,” said Altman. “That should result in more defaults in that sector than would have been the case.”
Too Complacent?
Many credit market participants expect defaults to rise gradually. Fitch Ratings forecasts that the default rates for each of US junk bonds and leveraged loans won’t hit 2% or more until 2024.
Indebted companies flooded the high-yield credit markets in the wake of the pandemic to refinance debt at ultralow rates, especially bond issuers. That means that the amount of bonds and loans coming due in the near term may be manageable for the market. Companies have also done a good job of cutting costs and shoring up liquidity
since 2020 which will help them weather an economic downturn, according to Chris Miller, senior research analyst and director of capital markets for fixed income at Neuberger Berman.
“All of those tools are still in their toolbox,” he said. “We actually expect defaults to remain pretty benign over the intermediate term.”
But others argue the pain could come faster. Priya Misra , a TD Securities strategist, sees the chance of a deeper downturn ahead after Powell’s comments regarding pain being required to get inflation under control.
“I don’t think that default risk premium has been priced accurately in the credit space,” Misra told Bloomberg Radio at the end of August. “I am concerned that the markets have become too complacent about interest rates, not quite appreciating that there’s true credit risk.”
Companies that borrowed in the leveraged loan market are especially vulnerable because their debt carries floating rates that rise as broader rates go up. The Secured Overnight Financing Rate, a market benchmark, has risen to about 2.3%, up from about .05% in March. UBS’s Mish sees companies’ debt rising relative to a measure of earnings, while the earnings that corporations have to pay interest fall relative to their obligations.
Some investors are preparing for the junk bond market to face more pressure. Pacific Investment Management Co., for example, is raising a credit fund that plans to capitalize on falling debt prices and weak companies that need fresh financing as interest rates rise worldwide and economies weaken, according to people with knowledge of the
matter.