The odds are rising that corporate borrowers will struggle to repay their debts as the Federal Reserve opts for jumbo interest-rate hikes to combat inflation, according to UBS Group.
Default rates for the US leveraged loans could next year rise to 9 per cent as long as the Fed stays on its aggressive monetary-policy path, UBS strategists wrote in a note.
They expect high-yield bonds to default at a peak rate of 6.5 per cent next year.
“The prospect of a higher terminal fed funds rate for longer raises the risks of a more severe credit cycle, in our view,” the strategists wrote. “Spread widening and downgrade risks are not priced in.”
UBS joins a chorus on Wall Street warning that defaults could become more common as company cash cushions erode and borrowing costs rise.
Analysts at Moody’s Investors Service and Citigroup both increased their default forecasts earlier this month.
The Fed is under even greater pressure to handle the hottest inflation in 40 years, after a reading of September consumer prices came in above expectations. Higher interest rates make it more costly for companies with floating-rate loans to cover the interest on their debt.
At the same time, risky debt in the Americas is piling up. The heap of dollar-denominated corporate bonds and loans trading at distressed levels had risen to $246.6 billion as of October 7, a 21 per cent jump from a week earlier, according to data compiled by Bloomberg.
For UBS, the sharp rise in risk extends across the credit spectrum. Spreads for investment-grade debt will likely rise to 170 basis points by the end of the year, according to UBS, from 163 basis points currently.
The strategists recommend allocating cash to super-safe A rated companies rather than those at the bottom of the investment-grade group.
Risk is rising that firms with a BBB grade could get slashed to junk as conditions worsen. BBB companies in the consumer cyclicals, consumer finance and telecoms sectors are at greatest risk for downgrades.