(Bloomberg) — The junkiest corporate debt is becoming increasingly hazardous for investors amid mounting signs that a default cycle is picking up steam.
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The holding company of Thames Water Ltd. this week failed to make payments that had come due on a £400 million bond ($504 million). It follows a plunge in the bond prices of Altice France last month after management told investors they would have to participate in “discounted transactions” to help the firm slash its debt.
As a result, investors are penalizing CCC rated debt even as wider bond spreads narrow to benchmarks. In the last two weeks, the extra yield on the riskiest European debt reached the highest levels since Covid-19 shuttered entire industries and the euro region debt crisis was raging more than a decade ago. In the US, the widening is less dramatic, but nonetheless happening.
For years, asset managers bought the lowest band of bonds to boost returns because cheap money from central banks made it less likely that corporates would default. After the fastest interest rate hikes in decades, some companies are beginning to struggle when they have to refinance their borrowings at a significantly more expensive level. The threat of haircuts for debt investors looms large as a result.
“There is going to be some pain ahead,” said Raphael Thuin, head of capital market strategies at Tikehau Capital. “Perceived wisdom is that it takes 18 to 24 months for rate hikes to take effect. We are in that period now.”
With central banks disappointing market hopes for a slew of interest rate cuts this year, the Bank of England warned last week that the risk of a widening in credit spreads has grown since the final quarter of last year and that “finance for riskier corporates could be particularly vulnerable to a significant deterioration in investor risk sentiment.”
That’s a potential problem for borrowers given banks, the other traditional source of lending in Europe, significantly reduced the rate of growth in their corporate loan books last year. Fitch Ratings sees the default rate on high-yield bonds climbing to 4% in the region this year from 1.7% in 2023, driven by leverage, debt maturities and declining performance.
One of the notable features of the CCC blowout in Europe and the US is the fact the spread between better-rated categories of high-yield debt remains relatively tight, as investors pile into junk, but steer clear of the riskiest category.
“CCC’s have been the huge underperformer,” Steven Fawn, head of global credit at Amundi Asset Management, said on the Bloomberg Intelligence Credit Edge podcast this week.
To be sure, debt rated CCC or below constitutes just 8% of Europe’s junk index, according to Bloomberg Intelligence, suggesting the problems will not become widespread.
“Our worst case scenario where all credits with a CCC- rating and below names default, the junk index default rate still won’t cross 2.4%,” said Heema Patel, a credit strategist from Bloomberg Intelligence. “So it does look like the CCC index is a bit oversold.”
Recent Downgrades
Still, Altice France SA and landlord Samhallsbyggnadsbolaget i Norden AB have been downgraded into the CCC bucket in recent weeks, while the rating of Kemble Water Finance Ltd., the owner of Thames Water, has been cut deeper.
“After a decade of free money and negative rates, some capital structures are unsustainable,” said Nicolas Jullien, a high yield portfolio manager at Candriam SA.
Click here to listen to a podcast about how Amundi expects AT1 bonds to extend gains.
Week in Review
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Investors are pouring money into US leveraged loan funds, fueling some of the biggest gains in credit markets this year, in a high-conviction bet that rates will be slow to fall and junk-rated corporate America will withstand the pressure of elevated borrowing costs.
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KKR & Co.’s contrarian bet that leveraged debt would beat investment-grade fixed income last year paid off, as recession fears faded and higher rates pressured blue-chip bonds.
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A bet that leveraged loan markets would rebound from the volatility that followed former UK Prime Minister Liz Truss’s disastrous mini-budget in 2022 has bagged a 146% return for a CVC Credit Partners’ collateralized loan obligation.
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Creditors of Thames Water Utilities have started to organize ahead of potential restructuring talks after its parent firm defaulted on its debts.
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Apollo Global Management Inc. is in talks to provide debt financing to support Saks Fifth Avenue’s potential acquisition of rival Neiman Marcus.
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Genstar Capital-backed Telestream is looking to raise around $400 million of fresh capital from direct lenders to pay down existing debt.
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Enbridge Inc. sold $3.5 billion of debt on Tuesday following a downgrade last week by Moody’s Ratings.
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Direct lending funds are having a hard time sourcing cash from their own investors, raising fears that the red-hot private credit market is set to cool.
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Barclays Plc and AGL Credit Management have teamed up to make a push into the burgeoning $1.7 trillion private credit market with backing from the Abu Dhabi Investment Authority.
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Companies are issuing a record amount of yuan-denominated bonds outside China as they seek to take advantage of the low cost of borrowing in the currency.
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An Ellington Management Group fund designed to buy residential mortgage debt returned about 24% from the start of 2023 through January as the Federal Reserve’s hiking cycle comes to an end.
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Real estate group Aroundtown SA is offering to exchange several old hybrid bonds into new ones to regain equity recognition and support its credit ratings.
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Herbalife Ltd. sold $1.2 billion in high-yield bonds and leveraged loans after boosting yields twice and adding lender-friendly protections to garner enough participation.
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Discount retailer 99 Cents Only Stores LLC announced plans to wind down its business operations.
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Acorda Therapeutics Inc., a company that makes drugs for neurological disorders, filed for Chapter 11 bankruptcy with a plan to sell its assets to another pharmaceutical company for $185 million.
On the Move
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Viking Global Investors’ head of credit, Patrick Dowd, has left the hedge fund after three years.
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Northern Trust Asset Management named Christian Roth as Chief Investment Officer of Global Fixed Income.
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Rothschild & Co. managing director Steven Berger has left the firm to join Raymond James Financial Inc.
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SMBC Nikko Securities America Inc. has promoted Dolph Habeck to head of its sustainable solutions team, effective April 1.
–With assistance from Helene Durand, Bruce Douglas and Alex Nicholson.
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