The specter of rising corporate debt defaults has long been disregarded by resilient credit markets, but now the fears are starting to materialize. Companies are facing downgrades to junk credit ratings, resulting in higher borrowing costs. The recent downgrade of Swedish landlord SBB and the debt struggles of Casino and Thames Water highlight the growing corporate debt crisis.
However, despite the increasing default risks, investors appear unfazed, as evidenced by low insurance costs for exposure to European junk-rated corporates. This complacency in the market is concerning, given the rise in global defaults. While hopes of economic resilience and an end to aggressive rate hikes fuel positive sentiment, analysts argue that the impact of rate increases has not yet been fully felt, and corporate bond yields should reflect higher risk premiums.
Default Rate Projections:
S&P Global predicts that default rates for U.S. and European sub-investment grade companies will rise by March 2024. They anticipate rates of 4.25% for U.S. companies (up from 2.5% in March 2023) and 3.6% for European companies (up from 2.8% in March 2023). Despite these projections, the belief that the world economy will avoid a sharp downturn and that rate hikes will soon cease has contributed to the optimistic outlook.
Corporate Bond Yields and Spreads:
Analysts argue that corporate bond yields should command a higher premium due to the potential risks involved. Currently, the spread on the ICE BofA global high-yield bond index is at 435 basis points, significantly down from 622 bps a year ago. This tightening of credit spreads indicates that the market is not fully acknowledging the existing risks. Zurich Insurance Group’s chief market strategist, Guy Miller, points out that the number of bankruptcies this year is on track to exceed 200, similar to levels seen during the global financial crisis and COVID-19.
Challenges and Restructuring:
While some companies have taken advantage of low interest rates to extend the maturity of their debt, refinancing will prove costly for those facing imminent debt maturities. The average maturity of European high yield corporate bonds hit a record low of almost four years in May, leaving firms with less time to refinance debt and increasing the impact of higher rates. Consequently, companies may face challenges in paying higher interest costs and refinancing maturing debt, leading to defaults.
To avoid immediate repayment or insolvency following a default, companies are engaging in talks with creditors to restructure their debt and turn their businesses around. Although the legal systems have evolved since the financial crisis to avoid disorderly wind-ups, the success of restructuring processes may vary. In Spain, the efficacy of a new restructuring law is being tested with the case of industrial group Celsa.
The rising corporate debt defaults present a significant risk to the global economy. Despite the current complacency in credit markets, the increasing number of downgrades and defaults suggest a growing crisis. The impact of rising interest rates is yet to be fully felt, and corporate bond yields should reflect the existing risks. While some companies may be able to navigate through the challenges with debt restructuring, not all will survive. Europe may experience a slower recovery compared to other regions. With uncertainties ahead, it is crucial to monitor the corporate debt situation and its potential impact on the broader economy.