Greater stress on junk corporate debt expected due to Fed hikes | ECONOMY

The lowest-rated US corporate borrowers are headed for financial trouble if the Federal Reserve raises its benchmark interest rate above 3% over the next year.

That is the view of UBS Group AG, which sees potential for a credit crisis at that level. Wall Street is currently pricing in a fed funds rate approaching that danger zone by the end of the February Fed meeting, and futures markets imply a 2.9% policy rate.

We remain of the view that the Fed cannot raise the fed funds rate to 3.25%-3.5% over the next year”, UBS strategists led by Matthew Mish wrote on Monday. “The greatest vulnerability lies with lower-rated speculative-grade loans”.

More than a quarter of America’s collateralized loan obligation portfolios have a B- credit rating, just one notch above the lowest tier, Mish wrote, and 80% of the issuers in those portfolios have capital structures. floating rate.

That makes those companies especially vulnerable to rising interest rates, which would rapidly increase their interest expense and reduce cash flow.

The leveraged loan market is already struggling with the fact that the Fed has signaled rate hikes of 50 basis points at each of its next two meetings, having this year raised the rate by a total of 0.75 percentage point from almost zero. .

The lowest-rated loans are significantly underperforming the rest of the market, and a significant drop in loan prices has made it difficult for companies to sell new debt.

Loan issuance has slowed dramatically in recent weeks, with several deals still trading past their maturity dates. Some other loan transactions have been fully archived.

Prices in the $1.2 trillion leveraged loan market fell to 95 cents on average last week, the lowest since November 2020.

The US investment grade market is doing much better. Despite widening spreads and sporadic issuance due to volatility, sales of new investment grade bonds are running slightly above last year’s pace.

Still, investors see danger for higher-rated companies if the Fed is forced to tighten monetary policy more aggressively than currently planned.

The spread over Treasury bonds in the Bloomberg US investment-grade index on Monday was 143 basis points. On the few occasions in the past 20 years that spreads crossed above 200 basis points, the flow of credit across the US economy has tended to contract.

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