Default rates are moving higher in the US loan market, as companies feel the pain of rising borrowing costs. Could the pain spread to the high yield market?
- There were 18 debt defaults in the US loan market between or the year to the end of May, higher than for the whole of 2021 and 2022 combined
- Refinitiv reports that high yield bond funds reversed seven weeks of outflows in April with their $3.6bn in inflows
- Less than 0.5% of the European high yield market has defaulted over the past 12 months, some way under the long-term average of 2%
Default rates have spiked higher in the US loan market, as the rising cost of borrowing has started to bite. It comes just one month after Refinitiv reported a recovery in inflows for high yield funds. Should signs of distress in the loan market give investors pause for thought on high yield bonds?
There were 18 debt defaults in the US loan market between or the year to the end of May, totalling $21bn, according to Financial Times reporting of Goldman Sachs analysis. This was higher than for the whole of 2021 and 2022 combined and suggests rising distress among indebted US corporates. There is now a question on whether this distress will spread to the high yield bond market. Companies could be forced to roll over debt at higher rates, or turn to bond markets as their loans become too expensive.
For the time being, investors have not been deterred, lured by tempting yields and signs that the US central bank may be coming to the end of its rate rising cycle. Refinitiv reports that high yield bond funds reversed seven weeks of outflows in April with their $3.6bn in inflows, their largest inflow for the year to date.
There have certainly been few signs of distress in the high yield market so far. If anything, default rate predictions have been coming down. Columbia Threadneedle recently pointed out that less than 0.5% of the European high yield market had defaulted over the past 12 months, some way under the long-term average of 2% and significantly behind predictions from Deutsche Bank and JP Morgan.
Its view was that easing natural gas prices, stronger corporate results and the reopening of China had all helped prevent defaults. Equally, there are signs of natural shrinkage in the market, with new issuance volumes anaemic. This has helped support high yield credit spreads and provided a technical tailwind for the sector.
It is clear that the dynamics of the loan market and high yield market are different and investors shouldn’t necessarily infer weakness in one market from another. Nevertheless, it is worth noting that while the income available from the high yield market looks superficially attractive, credit spreads are significantly tighter than they were during the financial crisis and also in 2011, 2016 and 2020, leaving investors with less margin for error.
There is no immediate risk to the high yield market from rising defaults in the loan market. However, it does point to a more febrile and difficult environment for the corporate sector. Credit spreads leave little margin for error, so investors should tread cautiously.
