Outlook for junk bonds gets cloudier as U.S. recession risks loom

As concerns over an impending economic slump increase, analysts have started to increase their default predictions for speculative-grade "junk bonds" issued by the United States.

When compared to historical data, the default rate for U.S. speculative-grade "junk bonds" is still low, currently below 2%. After the pandemic and the sharp drop in oil prices in 2016, which caused a number of energy producers in the industry to go bankrupt, default rates exceeded 8% in 2020.

The Federal Reserve's promise to control inflation has caused uncertainty to once again surface regarding the state of the American economy. The Fed's primary weapons in this fight have included fast raising its policy interest rate to make borrowing more expensive for individuals and businesses, as well as by reducing its balance sheet.

Companies that rely on junk-rated debt for funding are already considered to have a relatively high default risk, but greater borrowing costs over longer periods of time tend to increase this risk.

The default rate predicted by Barclays credit analysts for both speculative-grade U.S. junk bonds and loans for the coming year has been increased to a range of 5% to 6%.

In their reasoning, the team, chaired by Bradley Rogoff, cited "several variables that lead to increased default rates next year," such as sluggish growth, anticipation of squeezed business margins, and their experts' prediction of a mild U.S. recession.

In addition, a worsening macroeconomic environment prompted Matthew Corbett, senior analyst and head of high yield research at Columbia Threadneedle, to recently raise his prediction for the default rate on U.S. junk bonds to 4.3% for 2024 from 3.6% in April.

According to Corbett, the ultra-low rates that were accessible throughout the epidemic are part of the reason why consumer and corporate balance sheets are currently still solid. However, he also sees potential pressures escalating in more "cyclical" industries, such as leisure, retail, and healthcare, particularly if demand from consumers for services and products declines.

After St. Louis Fed President James Bullard said the central bank's rate may end up as high as 7%, up from the current 3.75% to 4% range, equities shook this week and bond yields increased.

Exchange-traded funds are a popular way for people to get exposure to junk bonds. The iShares iBoxx $ High Yield Corporate Bond ETF and were the two largest in the sector, and they both experienced weekly drops of 0.3% and 0.2%, respectively.

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