The Rabid Capitalist

Professor Glenn A. Okun

As if the looming commercial real estate and corporate debt maturity paywall was insufficient trouble, corporate bonds have been eroding in credit quality as well.  Credit downgrades and negative outlooks have risen recently.  This represents a dual threat to the capital markets. 

Credit quality is critical to the health of the debt capital markets.  Declining credit quality is associated with increasing default risk and investment losses.  Credit downgrades lead to higher interest rate spreads.  Rising interest rates further strain the operation of weakened issuers, increasing bankruptcy risk.

These adverse conditions in the debt markets represent a present and future danger.  Downgrades, the current threat to the market, are underperforming firms where their elevated risks warrant wider credit spreads and higher debt costs.  Negative outlooks, the future menace, are firms at risk of downgrade. 

For the first time since 2021, credit downgrades exceeded upgrades.  This downgrade-to-upgrade ratio remained the largest among speculative grade issuers.  Furthermore, the volume of the lowest investment grade debt placed on negative outlook and at risk of a downgrade to junk bond status had nearly doubled to 5.7% compared to one year ago according to B of A Securities.  Positive outlooks, or upgrades, fell to 5.3% from 7.9%. 

While current demand for credit has been very strong due to motivated investors locking in attractive yields in anticipation of the Federal Reserve easing interest rates, it is unrealistic to expect the degree of elevated demand that would be needed to absorb the growing supply of junk-rated securities at current debt costs for the issuers.

Based upon historical norms, a significant widening of interest rate spreads should be expected.  The increase in the interest spread could more than offset any decrease in interest rates.  This would represent a significant threat to highly leveraged firms.

The interest rate spread and credit risks magnify the debt maturity paywall threat to the credit markets.  Lenders and borrowers will face a more hostile climate as a result.  Traditional lenders and credit-intensive businesses should be avoided.

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