You do know that you don’t come out of a decade of artificially low interest rates unscathed, right?
I’ve talked about the risk of credit spread widening and default risk in the bond market before and I maintain that we are in a very challenging part of the cycle. Most crises in markets are refinancing crises, meaning that as highly levered junk debt issuers roll over their debt into higher rates, with razor thin margins on their own respective bottom lines, there becomes increased risk that companies won’t survive.
Here’s where it gets scary – more debt is no longer rated AAA, and more is considered junk.
The burgeoning amount of outstanding junk debt poses a significant risk to risk assets. Why? Let’s first define what exactly junk debt is.
What Is Junk Debt and Why Does It Matter?
Junk bonds are debt securities with a credit rating of BB or lower by Standard & Poor’s, and Ba or lower by Mood’s. These bonds offer a higher yield than investment-grade bonds to compensate for the increased risk of default.
Junk bonds are an essential mechanism in the financial world. They offer higher potential returns, making them attractive to investors willing to embrace higher risk. Conversely, the risk associated with junk bonds also makes them a potential hazard, particularly in an unstable economic climate.
There is currently more junk-rated debt than AAA-rated debt in circulation. This shift is not only due to the downgrade of U.S. government debt from AAA to AA+ by Fitch but also due to the continuous accumulation of debt at very low interest rates in recent years.
These circumstances have led to the proliferation of “zombie companies,” firms that would have struggled to survive under normal rate environments. As we approach a period of potentially prolonged, higher interest rates, these companies could face significant financial challenges that may push them toward bankruptcy.
With junk bond debt continuing to rise, the implications for the financial market and investors are substantial. As interest rates rise and economic conditions tighten, the risk of default on these high-yield bonds becomes increasingly significant. A significant portion of the outstanding junk debt will need to be refinanced in the coming years. S&P Global estimates that the amount of debt requiring refinancing will rise steadily through at least the end of 2026, with a lot rolling over next year.
The Bottom Line
Refinancing at significantly higher rates could push the issuing company over the edge, leading to defaults and potential bankruptcy. This looming refinancing risk is a ticking time bomb in the financial market and is a significant contributor to the potential credit shock in corporate debt (what I’ve called Phase 2).
The popularity and performance of junk bonds traditionally follow the boom-and-bust cycles of the economy. During economic downturns, many investors opt for junk bonds, expecting market conditions to improve and the value of the bonds to rise alongside the fortunes of the corresponding companies.
However, the correlation between junk bonds and economic cycles also implies that during economic upswings, the demand for junk bonds may decrease as investors shift to safer assets. This shift could saturate the market with junk bonds, driving their prices downwards and increasing the risk for investors who hold these bonds.
Do you believe in a recession? If so, you believe junk debt does poorly. And if junk debt does poorly, given just how much there is out there, it’s hard to argue that we end up having a soft landing. If anything, the sheer amount of credit risk in the corporate sector argues it could be far more significant economic and financial crisis than most realize.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
