There’s A Ticking Time Bomb At The Center Of America’s Economy

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There’s A Ticking Time Bomb At The Center Of America’s Economy

John Hugh DeMastri on September 6, 2022

As defaults in the junk-loan market reach their highest levels in two years, investors are worried that the worst is yet to come, according to The Wall Street Journal.

In August, debtors defaulted on a combined $6 billion of leveraged loans, a class of loan given to those who already have a significant amount of debt, according to the WSJ, citing financial analytics firm Fitch Ratings. While the broader leveraged loan market has doubled over the past decade to $1.5 trillion, financial analysts anticipate further defaults, the WSJ reported.

“The canary in today’s credit coal mine could well be leveraged loans,” said Morgan Stanley strategist Srikanth Sankaran in a research note, according to Bloomberg. Sankaran said that since the companies that typically take these loans are vulnerable to the “double whammy” of weaker earnings and rising interest rates, there is the potential for a “downgrade wave” that impacts debtors of all levels.

The rate of defaults on leveraged loans is expected to more than triple from around 1% at time of writing to about 3.25% in mid-2023, according to the WSJ, citing British bank Barclays PLC. By this time next year, that number could rise to 4.5%.

When a company defaults on its loans, they may be forced to reorganize or have their assets liquidated in bankruptcy court, according to Fidelity Investments.

This is lower than the spike of 7% in 2020, but that default crisis was cut short by the Fed cutting interest rates and  adding cash to markets, according to the WSJ. Since the Fed is not expected to drop rates soon, this elevated level of defaults could persist for up to three years, the WSJ reported.

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Fed Reserve Chair Jerome Powell, in a speech at Jackson Hole outlining the Fed’s strategy to fight inflation, made it clear that the Fed was willing to put households and businesses through “some pain” now in order to prevent “far greater pain” later.

The leveraged loan market has been a matter of some concern to Fed regulators since at least 2015, when former Fed Chairwoman Janet Yellen advised that lenders limit loans to risky borrowers, the WSJ reported. The amount of loans has since doubled to between $1.4 to $1.7 trillion, according to estimates from a variety of banks and financial analysts questioned by the WSJ.

Companies with single-B ratings, an extremely low junk-debt rating, account for roughly one-quarter of leveraged loans, according to the WSJ, citing data from Newfleet Asset Management. This is up nearly two and a half times from 2010, when 11% of such loans were held by single-B companies.

“They’re the marginal borrower,” Frank Ossino, a leveraged-loan fund manager for Newfleet, told the WSJ about single-B companies. “If their earnings go down and their interest expense goes up, eventually they can’t afford the debt.”

The Federal Reserve did not immediately respond to a Daily Caller News Foundation request for comment.

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