Defaults Set to Soar Amid Rising Borrowing Costs and ‘Extremely High’ Recession Risk

U.S. Federal Reserve Chair Jerome Powell speaks during a news conference in Washington, on June 15, 2022. Olivier Douliery/AFP via Getty Images

An association of fund managers has issued a dire prediction about the growing risk of credit defaults, warning that central bank interest rate hikes will trigger a wave of corporate defaults as borrowing costs soar and the threat of a global recession looms.

Not a single member of the International Association of Credit Portfolio Managers (IACPM) expressed the view that corporate defaults would decline, according to the latest quarterly survey carried out by the group and released on July 14.

“Rather, an overwhelming majority believe defaults will rise in North America, Europe, Asia and Australia,” IACPM said in a statement.

The survey was conducted among the association’s members, which include portfolio managers at many of the world’s biggest commercial banks, investment banks, and insurance companies.

The association’s latest credit default outlook score came in at minus 82.3, a sharp drop from the prior quarter’s minus 58.0, which in turn was far lower than the positive 2.6 notched nine months prior. Positive numbers reflect expectations for improved credit conditions, while negative ones suggest belief in a coming squeeze.

“Looking at these results, it’s almost impossible not to think the risk of recession is extremely high virtually everywhere around the globe,” Som-lok Leung, executive director of the IACPM, said in a statement.

“In the financial markets and among our members, there is an increasing view the US Federal Reserve will have to induce a recession to get a grip on rising inflation,” he added.

Europe is in a worse position than the United States, where consumers and businesses have substantial liquidity and where defaults are at historical lows, IACPM said. Still, America is far from immune to default risk, Leung noted.

“Defaults are currently at rock bottom but that will change as we go through the year,” Leung said. “Consumers and businesses have a bit of a cushion for now but our members expect to see significantly higher numbers of defaults in 2023 and perhaps even in 2024.”

Fed’s Inflation Fight

The Fed has been struggling to get a handle on soaring U.S. inflation, which in June hit a fresh 41-year high of 9.1 percent.

The central bank has also expressed concern about a rise in future inflation expectations, which threaten to become a self-fulfilling prophecy and further amplify inflation if not brought to heel. Year-ahead inflation expectations in the United States have soared to record highs.

The median one-year-ahead inflation expectations rose to 6.8 percent in June from 6.6 percent in May, marking a new series high, according to a recent survey by the New York Federal Reserve.

The Fed has embarked on a monetary tightening cycle in a bid to cool red-hot price pressures, hiking rates at its latest policy meeting by 75 basis points to a target range of 1.50–1.75 percent.

Data showing an uptick in the rate of inflation when the numbers were released earlier in the week prompted heated speculation that the Fed would have to get more aggressive in its inflation fight.

Economists and traders are now more or less evenly split in their expectations for a 75 basis point hike and a 100 basis point rise in the benchmark rate when Fed officials convene at the end of July.

Fed funds futures contracts show a 51.3 percent chance for a 0.75 percentage point hike, while putting the odds of a 1.00 percentage point rise at 48.7 percent, according to the CME FedWatch Tool, as at the time of reporting.

As nations around the world turn to tighter monetary policy to tame high inflation, the IACPM said survey respondents widely noted that rate hikes are a “blunt instrument” that carries a “serious risk of overcorrection.”

“The risk of monetary policy is well known and well entrenched at this point as is the continuing risk of inflation and the threat of recession,” Leung said.

“Risk is high and it’s everywhere.”

Uncertainty Driving Investors to Cut Risk

Growing concerns about a possible recession are leading some investors to reduce risk in their credit exposure.

As rising interest rates add to pressure in credit, some investors are looking to trim exposure to lower-rated credits and pivot to bonds of companies that are likely to be more resilient if a recession hits.

“We will always own high yield, we'll always own some emerging markets, but I think we probably just want to own less going forward in the next three months, six months,” Nick Hayes, head of global strategic bonds strategy at AXA Investment Managers, told Reuters.

“We want to improve the quality of the overall portfolio because maybe we are heading into a really uncertain time,” he added.

But higher interest rates are likely to thin supply, posing a challenge for bond traders looking to distribute their exposure between secondary and primary markets, traders told Reuters.

Earlier in July, high-yield spreads hit a two-year peak of about 600 basis points, with Bank of America strategists telling Reuters that the Fed has never raised rates when credit conditions were this tight.

Still, high-yield spreads are not showing levels of stress associated with some prior crises.

Spreads widened to more than 2,000 basis points during the 2008 financial crisis and to over 1,000 basis points in early 2020 at the start of the pandemic.