Credit markets on edge amid bankruptcies, Fed tightening

On Wednesday, the Federal Reserve is expected to raise interest rates by another 0.25%, bringing the short-term policy rate to a range between 1.50% and 1.75%. This is the first policy meeting headed by new chairman Jerome Powell, and it will feature an update to the Fed’s economic projections.

Key factors to watch include whether the Fed plans on three or four quarter-point hikes this year, and where they see the balance of risks to their inflation and economic growth forecasts. And as a reminder, the Fed is concurrently accelerating the drawdown of its holdings of Treasury bonds and mortgage-backed securities.

All this comes amid rising tensions in the credit markets, as worries about wage-push inflation, fiscal malfeasance out of Washington (thus increasing Treasury bond supply) and rising default rates usher in concerns that the long bond bubble could be coming to an end. The two-year Treasury bond yield has increased from the lows of around 0.20% set between 2011 and 2013 to trade above 2.30% last week for the first time since the summer of 2008—before the worst of the financial crisis struck. Interbank lending rates are surging as well.

Amid very lax credit standards and an obsession with “cov-lite” loans, corporate default rates are creeping higher. Losses will follow.

Already, the S&P/LSTA Leveraged Loan Index jumped to three-year highs at 2.42%. This comes after iHeartMedia, one of the largest survivors of the leveraged buyout boom, filed for Chapter 11 bankruptcy protection. According to Fitch, the iHeartMedia bankruptcy pushes its high-yield media subgroup default rate to 20% following bankruptcies at Cenveo and Cumulus.

The retail sector is under pressure as well, with Fitch warning that the high-yield default rate in this sector is poised to reach 11%—compared with an overall US high-yield default rate of 2%—because of the drag from PE-backed Claire’s Stores and Toys R Us. Other retailers on the brink include David’s Bridal (also PE-backed) and Sears Holding Corp.

Things look set to get worse. The Institute of International Finance recently noted that corporate downgrades keep outpacing upgrades for high-yield firms as analysts take a dim view on the future. Moody’s is looking for at least six retail and apparel companies to default on their debts over the next 12 months, pressured not only by the dynamics described here but also the ongoing onslaught from Amazon and other online competitors.

Bond maturities for distressed retail issuers will spike in 2019, when the Fed will likely push its policy rate above 3%, forcing default rates higher as highly leveraged companies are either unable to issue new debt or are forced to issue at higher rates, squeezing profitability under the weight of higher interest payments.

Investors aren’t waiting around. According to Bank of America Merrill Lynch, last month investment-grade bond funds saw their first net fund outflow in 60 weeks ($2 billion) while high-yield bond outflows hit their second-highest weekly redemption on record ($10.9 billion). Since then, high-yield outflows have continued for eight straight weeks.

The situation is a powder keg as years of low rates have encouraged aggressive corporate borrowing. Yet default rates haven’t followed the rise in indebtedness as those low rates have pushed down interest servicing costs. The disconnect can be seen in the chart from Moody’s above. Unless the laws and dynamics of corporate finance have changed (and—spoiler alert—they haven’t) the gap will eventually close.

The most vulnerable areas of the credit markets are headed for a nasty, self-reinforcing cycle: Higher rates lower bond prices and raise default risks, encouraging investors to sell, which further lowers prices and raises rates.

The fire is already smoldering. Powell’s first rate hike could pour on the gasoline.