Global Junk Debt Flashes Warning on Growing Risk of Stagflation

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(Bloomberg) — Fears of a stagflation shock from the Middle East conflict are increasingly souring investor sentiment toward the weakest global corporate borrowers, many of which binged on cheap debt during the era of ultra-low interest rates.

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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 $2 trillion leveraged buyout boom is concentrated.

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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’s heaping pressure on to lower-rated companies that don’t have the financial wherewithal of their better-ranked peers.

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“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 $900 billion. “That can be pretty challenging to overly levered companies.”

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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% this quarter, while BB rated ones have returned 1.4%, a Bloomberg index shows. 

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“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.   

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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% yields globally but their shorter duration make them less sensitive to underlying moves in government debt.                 

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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 dollar market neared the widest since the global financial crisis last month, according to Goldman Sachs Group Inc.

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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.” 

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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.