Junk Bond Defaults Are Rising, Despite Healthy-Seeming Economy, S&P Says

U.S. junk bond default rates are edging up, now at 3.2% of issuers, and likely will rise more than a full percentage point by mid-2024, to 4.5%, according to S&P Global Ratings. In the worst case, meaning a recession has arrived, the rate could hit 6.5%, the agency warned in a report.

High-yield defaults are viewed as harbingers for the economy, as they reflect the condition of the weakest companies. If junk defaults reached 6.5%, that would equal where they were in the brief 2020 recession, but nowhere near the 10% level of 2008, amid the financial crisis. S&P also had a best-case scenario for 2024 in which the economy achieved a soft landing: The default rate would then fall to 2%.

Right now, the nation’s economy appears to be in decent shape, with economists dialing back their earlier forecasts that a recession would arrive in late 2023 or early 2024. Unemployment is low, and gross domestic product growth, while sluggish, inched up in this year’s second quarter to 2.4% annually from 2.0% in the previous period.

But there are some worrisome forces at work, as the S&P research paper recounted. “In our base case, we expect defaults to continue rising as corporates grapple with higher interest rates and slower growth ahead,” it stated. “Rising rates are eroding profitability, and second-quarter earnings estimates forecast declining profits relative to a year ago, in aggregate.”

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Weaknesses are appearing in the consumer-oriented sectors, noted the report, by S&P’s Nick Kraemer, head of ratings performance analytics, and Jon Palmer, associate director for credit research and insights. They wrote that consumer products, media and entertainment, retail and restaurants “comprise a large portion of our weakest issuers … and show early signs of strain.”

Moreover, the default trend is upward. Torsten Sløk, chief economist at Apollo Global Management, told Barron’s last week that he worried about the current escalation of junk-rated companies not meeting their payment obligations: “This pickup in defaults started very unusually when we have a strong economic backdrop.”

On the other hand, there is a school of thought that junk defaults will be milder up ahead. Take Gurpreet Gill, macro strategist for fixed income and liquidity solutions at Goldman Sachs Asset Management. In a firm video presentation, she argued that junk is higher quality these days because the shakier credits went out of business during the pandemic.