Global junk debt flashes warning on growing risk of stagflation

[TOKYO/SINGAPORE/LONDON] Fears of a stagflation shock from the Middle East conflict are increasingly souring investor sentiment towards the weakest global corporate borrowers, many of which binged on cheap debt during the era of ultra-low interest rates.

Global investors now require about 6.4 percentage points of extra yield to own high-risk CCC rated bonds over other junk notes that sit just below investment grade, the largest premium in 14 months, Bloomberg indexes show.

Credit funds are bracing for even greater stress in higher-risk loans and private credit where debt from a US$2 trillion leveraged buyout boom is concentrated.

More than three months into the Iran conflict, higher oil prices are compounding risks for highly indebted borrowers. The prolonged closure of the Strait of Hormuz has pushed up inflation, which threatens to keep interest rates higher for longer and endanger economic growth. That is heaping pressure on to lower-rated companies that do not have the financial wherewithal of their better-ranked peers.

“If this transition from disinflation to reinflation leads to stagflation then you have that pernicious combination of declining operating cash flow and rising costs of capital,” said Mitch Reznick, group head of fixed income in London at Federated Hermes, which manages more than US$900 billion. “That can be pretty challenging to overly levered companies.”

Signs of diverging fortunes within US leveraged loans are also apparent. On a returns basis, CC rated loans using composite rating scores have lost 8 per cent this quarter, while BB rated ones have returned 1.4 per cent, a Bloomberg index shows.

“Whether we have a recession or not, we are going to have a default cycle” because of debt tied to a 2021-2022 leveraged-buyout bubble, Holly Kim, co-founder of hedge fund Glendon Capital, said at Bloomberg’s Global Credit Forum in New York this month. Kim agreed with a poll of forum attendees that found “stagflation” to be the biggest risk to credit markets.

Still, credit investors broadly remain bullish about the ability of companies to cope with higher borrowing costs, and US junk bond spreads recently approached the two-decade low touched in January. The allure of the bonds is that they pay on average about 7 per cent yields globally but their shorter duration make them less sensitive to underlying moves in government debt.

Investors in both US dollar and euro-denominated bonds are also demanding larger premiums to hold B rated bonds relative to BB ones.

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The option-adjusted spread ratio, calculated by dividing the average yield premium of the lower-rated bond index by the higher one, in the US dollar market neared the widest since the global financial crisis last month, according to Goldman Sachs.

The resilience of BB debt reflects, in part, a “flight to quality,” strategists including Amanda Lynam wrote. “We attribute this sentiment to the overhang of geopolitical and macroeconomic uncertainty.”

Globally, there is now a fivefold difference in CCC and BB credit spreads, the highest multiple in more than a decade, pointing to growing bifurcation in credit markets, based on the available data.

The divergence becomes clearer when performance is broken down by ratings category. While investors require lower spread compensation for holding BB rated global corporate bonds than they did at the start of the year, yield premiums on global CCC rated bonds have widened by 86 basis points. Single-B debt has also underperformed relative to the overall market.

“It is a very bifurcated market in high yield,” David Forgash, Pimco’s head of leveraged finance, said on Bloomberg Television. The speculative-grade market “feels a bit complacent” because debt paying much higher spreads is “hiding beneath the surface in that tighter spread product,” he said.

Pimco has also warned that a decade-long boom fostered sloppy underwriting in some parts of the private credit that is now also under pressure due to a concentration of direct lending to AI-threatened software companies.

Defaults in the US$1.8 trillion market could surge to as high as 15 per cent if AI triggers an aggressive disruption among corporate borrowers, UBS Group strategists wrote earlier this year.

Consumer-facing companies in particular are drawing scrutiny, and markets may still not fully reflect the risks they face, according to Federated Hermes’ Reznick, who broadly prefers higher-quality credit.

“It is time to steer a little bit clear of highly levered companies that are exposed to the consumer,” he said. “We don’t think you get paid right now to chase default risk for returns because if you get it wrong, it is very hard to recover those losses.”

Europe may also be more vulnerable than the US to stagflationary impulses if the Strait of Hormuz remains closed, he added.

Within Europe, chemicals, packaging, auto components and real estate have all struggled this year, said Raphael Thuin, head of capital markets strategies at Tikehau Capital in Paris. “Sectors hit by tariffs and energy prices or Chinese competition are often displaying large discounts.” BLOOMBERG