In March, April, and May, 120 junk-bond issues worth a total of $136 billion saw their credit ratings downgraded, more than at any time since 2020 during the heat of the COVID War, JPMorgan reported.

Junk bonds typically have variable interest rates, which have been rising steadily for 16 months as the U.S. Federal Reserve has kept lifting them higher to beat back inflation.

Companies that had their creditworthiness downgraded include Aspen Dental, Confluence Technologies, and MedData.

The Fed held interest rates at artificially low rates through the ‘teen years and ambitious companies, or those facing financial headwinds, piled on cheap debt.

They had gambled that interest rates would remain low for years to come but they lost that bet.

“There’s an immediate impact on their entire capital structure, their entire debt liability, as soon as rates move,” Steve Purdy, chief credit researcher at asset manager TCW, said to the Financial Times.

Now that their credit ratings have been lowered, the companies will either have to pay higher interest rates if they try to borrow more, or they might find that no one is willing to lend to them.

The ratings slide poses a particular risk to a segment of the bond market known as “collateralized loan obligations” (CLOs), which buy loans in bulk, group them by risk levels, and sell them to investors. 

CLOs often are structured so that when too many companies are down-rated, that trips a financial safety switch: those companies are cut off from additional funding and money is diverted to safer corporations with better credit ratings.

Typically, that switch is tripped when 7.5 percent of a CLO’s holdings fall far enough to be rated CCC, the bottom of the junk-bond barrel, the FT said.

Also, the more corporations that slide down the ratings scale, the more of them that will default. 

On 30 June, the default rate among corporate bonds overall stood at 4.1 percent, compared to 3.7 percent in May and 1.4 percent a year earlier, Moody’s said. Among junk bonds, the default rate was just 1.7 percent at the end of June, a slight increase from May’s 1.4 percent.

June’s defaults included Instant Brands, a kitchenware business, and TPx Communications.

“Healthcare and software are the two sectors that we think could see elevated default activity,” leveraged loan manager Kevin Wilson at Pinebridge Investments told the FT. “The two account for the largest percentage of the market trading at distressed levels.”

TREND FORECAST: As we noted in “$500 Billion in Distressed Corporate Debt Presages Wave of Bankruptcies” (25 Jul 2023), the bond market’s current mess has heavily leveraged companies trying to pay their bills in a slumping economy presided over by skeptical lenders less likely to be interested in refinancing troubled debt.

The more bonds that are downgraded or default outright, the more likely it is that higher-rated bonds will slide down the ratings scale to take their place. A troubled bond market is unlikely to leave even highly-rated bonds untouched. 

The continued rise in bankruptcies and defaults will ripple through the economy and push the U.S. closer to recession.