U.S. Federal Reserve pivot may cap junk bond defaults, but risks remain

Investor optimism boosts demand for junk debt, providing relief to lowest-rated companies & likely capping default rates in 2024.

Investor optimism that the Federal Reserve will start cutting interest rates is breathing new life into the market for junk debt, providing timely relief to the lowest-rated companies and likely capping the rate of defaults in 2024.

As the U.S. central bank started to raise rates in 2022 and worries about defaults grew, companies rated below investment grade saw tepid demand from investors for their loans and bonds.

Many such firms turned to roundabout ways to raise money to get ahead of a $300-billion wall of bond and loan maturities in the next two years.

In the last few months, however, yields have fallen as investors bet the Fed, emboldened by its progress in slowing a surge in prices that pushed inflation to 40-year highs last year, will soon start cutting rates. Markets are now pricing the U.S. central bank’s key policy rate to fall as much as 1.5 percentage points below the current 5.25%-5.50% range by the end of next year.

Expectations of such a pivot have led to a resurgence in demand for high-yielding debt.

Junk bond spreads, or the premium investors charge over U.S. Treasuries for taking on the risk, have on average tightened 38 basis points since September to 343 basis points, the lowest level since April 5, 2022, according to the ICE BAML index.

In December, insurance brokerage USI Inc., a company rated deep in the junk territory, became the first borrower in its category to tap the primary markets since April, according to data provider Informa Global Markets.