Investors and economists have become optimistic that the Federal Reserve might successfully slow inflation without plunging the economy into recession, but many are still eyeing a risk that threatens to derail the effort: a tower of dicey-looking corporate debt.
Companies loaded up on cheap debt during an era of superlow borrowing costs to help finance their operations. The Fed has since lifted interest rates to a range of 5.25 to 5.5 percent from near zero, where they were as recently as March 2022.
The fear is that as debt comes due and businesses still in need of cash are forced to renew their financing at much higher interest rates, bankruptcies and defaults could accelerate. That risk is especially pronounced if the Fed keeps borrowing costs higher for longer — a possibility that investors have slowly come to expect.
Already, corporate defaults this year are running at their fastest pace in more than a decade for companies with public debt that trades on financial markets, outstripping the immediate aftereffect of the pandemic’s start in 2020, according to S&P Global Ratings. Another $858 billion of bonds and loans carries an S&P rating of B– or lower, a level that designates the debt as being in a precarious position. The rating agency is also tracking more than 200 companies that it says are acutely suffering from severe stress — many of them from the effects of higher interest rates.
The bankruptcies that have happened this year haven’t seriously dented the economy so far. But analysts have warned they are symptomatic of the excesses that developed during a decade of historically low interest rates. And financial stress is unpredictable, so it poses a wild-card risk for the Fed as it tries to tame inflation. It hopes to do that without causing a recession.
“The financial system is this machine, and it’s shaking terribly because of all the stress put on it,” said Mark Zandi, chief economist of Moody’s Analytics, referring to pressures from higher interest rates, among other strains. “The Fed is desperately trying to keep it from blowing a gasket.”
Financial vulnerabilities are not the only risk to the economic outlook. Consumers could pull back more sharply as they whittle away at savings amassed during the pandemic and as they themselves face higher borrowing costs. That in turn might constrain companies’ ability to pass on costs and protect profits. And if inflation stays elevated longer than expected, the Fed may need to clamp down even harder on the economy.
But even if rates do not rise much further, economists said, the risk of a financial blowup is a disconcerting — if hard to quantify — threat.
The longer interest rates remain elevated, the deeper the stresses are likely to become. An inability to secure affordable financing could cause firms to pull back on expansions or shut down in large numbers, leading to job losses, curtailed growth and potentially dashed hopes that the Fed will be able to gently glide the economy to what is known as a soft landing.
A recent paper by Fed researchers dug into what the effect could be and found that companies in precarious financial situations — about 37 percent of the publicly traded firms reviewed by the researchers — are likely to struggle to secure financing when rates are climbing, causing them to pull back on expansions and hiring.
Those knock-on effects could be “stronger than in most tightening episodes since the late 1970s,” the researchers wrote.
The challenge — for both investors and Fed officials — is that interest rate increases work with long lags, meaning that the full effect of higher borrowing costs will take time to show up.
In the meantime, the economy has proved resilient even as interest rates have risen, luring investors into debt markets on the promise of historically high returns and the hope that companies will still be able to pay them back.
The fear of missing out has been compounded by the searing stock rally that has lifted the S&P 500 roughly 20 percent this year, even as recession fears dominated the narrative, said Dominique Toublan, head of credit strategy at Barclays.
“It’s FOMO right now,” he said. “Most of us have been wrong on the timing of things going bad, and right now there is really not much of a problem. That is the conundrum. It feels like it could go either way.”
The economy’s resilience, however, could also be its undoing.
Borrowing costs in the $1.5 trillion leveraged loan market — where risky, often private-equity-owned companies tend to finance themselves on more aggressive terms — are quicker to adjust to the ups and downs of interest rates. But it can still take up to six months for the higher payments to come due.
In the similarly sized high-yield bond market,…
Read More: Credit Markets Are Creaking, Creating Economic Uncertainty