Junk Debt Sends Early Warning Signals

Junk Debt Sends Early Warning Signals

Warning signals are starting to flash in the market for junk debt, an indicator that investors are worried that companies with high debt loads could be at risk even if the U.S. economy avoids recession.

The current change in sentiment is modest compared with the one that hit high-yield bonds in December. But it continued through a recent surge in demand for Treasurys and investment-grade corporate debt. The combined trends expose cracks in the recent rally that has powered the Dow Jones Industrial Average to within 0.6% of its July record.

Forecasting downturns in corporate debt has been tricky since the financial crisis. Central bankers have been reluctant to raise interest rates for fear of triggering a slowdown. The resulting decade of cheap money allowed riskier companies to borrow more to stay afloat, keeping default rates low for an unusually long time.

That could continue as long as the Federal Reserve and European Central Bank maintain their cautious approach. The Fed is expected to cut rates a quarter percentage-point at its September meeting this week.

Nevertheless, more bond specialists are trimming back on high-yielding debt to protect against losses should the credit cycle again turn.

Here are some bellwethers of the growing junk-debt anxiety.

By one key measure, the risk in the high-yield bond market is at its highest level since 2016, when a sharp slide in oil and natural-gas prices triggered a string of energy-sector defaults. The U.S. distress ratio, which is the proportion of junk bonds that yield more than 10 percentage points above Treasurys, jumped to 9.4% in August this year from around 6% in July, according to data from S&P Global Ratings.

Bond yields rise when investors demand higher compensation for lending out their money. A surging distress ratio reflects a sharp change in risk appetite.

“We think fundamentals are weakening even if the U.S. avoids a recession,” said Matt Eagan, co-manager of the $10.8 billion Loomis Sayles Bond Fund, which invests in a mix of corporate debt and equity. The fund has cut its exposure to junk debt to 22% from about 26% at the start of the year; it has raised its allocation to cash and Treasurys slightly, to 26%.

Declining earnings and rising debt loads are crucial to measuring credit quality. But access to fresh capital is equally important to junk-rated companies—they usually lack the cash to pay off debt as it comes due and rely on refinancing.

That has become more costly in recent weeks as investors have pivoted away from borrowers with below-investment-grade ratings toward companies that are more stable but pay lower yields. Investors pulled about $6 billion from mutual funds and exchange-traded funds that buy high-yield bonds and leveraged loans and put almost $20 billion into investment-grade corporate bond funds in the six weeks ended Sept. 11, according to data from Lipper.

The liquidity squeeze forced junk-rated companies to sweeten terms of new deals to attract sufficient interest. About one-quarter of borrowers in the leveraged-loan market cut pricing during their marketing processes in August, up from 20% in July and 17% in June, according to data from LCD, a unit of S&P Global Market Intelligence.

Default rates may remain low if easy monetary policy persists. But junk bonds and loans are also risky because they can suddenly drop from one credit-rating category to another due to declining earnings, rising debt loads or both, Mr. Eagan said.

“A lot of people think mostly about defaults and don’t realize the losses that can come from downgrades,” he said.

A steep decline in the price of loans with triple-C ratings—the lowest rung in the credit-ratings ladder—is a sign investment firms are preparing for more downgrades to the bottom category.

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Most managers of mutual funds and collateralized loan obligations, or CLOs, have restrictions on how much triple-C debt they can hold. They typically jettison loans with the low rating when they expect more single-B loans to get cut to triple-C.

The selling triggered losses in triple-C-rated loans in August for the first time this year, counting price changes and interest payments. Meanwhile, safer loans with double-B ratings posted gains.

“CLO managers are creating space because they’re sensitive to the risk of more loans getting downgraded to CCC,” said Joseph Rotondo, a senior portfolio manager at Invesco Ltd., which manages $32.5 billion of leveraged-loan investments.

Write toMatt Wirz at[email protected]

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