Prolonged High Interest Rate Outlook and Economic Slowdown Concerns
Companies Rapidly Increasing Worries Over Default Domino Effect
As the European economic recession accelerates, yields on 'junk bonds,' which are non-investment grade corporate bonds, are soaring. Analysts suggest that the risk premium is increasing amid concerns that a domino effect of corporate defaults could occur due to prolonged high interest rates and economic slowdown.
Junk Bond Yields Surge
According to the ICE Bank of America (BofA) index on the 22nd (local time), the yield spread between euro-denominated corporate bonds and government bonds with credit ratings of 'Triple C (CCC)' or lower averaged over 18 percentage points. The Triple C or lower rating is the lowest grade within the junk category below the non-investment grade 'BB+' rating, indicating an imminent default.
This spread is the largest since June 2016 and has widened by more than 10 percentage points compared to early last year (6.7 percentage points), before the central banks began their full-scale interest rate hikes.
Compared to the U.S., the spread between European junk bonds and government bonds is also higher. In the U.S., the spread between Triple C rated corporate bonds and government bonds is around 10 percentage points, much lower than Europe's 18 percentage points.
This indicates that investors are demanding increasingly higher yields to prepare for the risk of European economic recession and corporate defaults caused by aggressive central bank rate hikes. According to global credit rating agency Moody's, French retailer Casino Group, Dutch manufacturer Keter, and Belgian company Ideal have recently failed to repay corporate bonds or loans.
From the companies' perspective, they now have to raise capital by offering premiums higher than before. For example, Altice, a French telecommunications company accounting for 4.7% of Europe's Triple C corporate bonds, has corporate bond yields reaching 29% for bonds maturing in 2027.
Impact of European Recession... Will Liquidity Tighten?
The rise in junk bond yields is largely due to rapidly tightening credit conditions caused by high interest rates. The relatively smaller size of the European junk bond market compared to the U.S. also stimulates yields on European default-risk corporate bonds. The European junk bond market is estimated at 412 billion euros, about one-third the size of the U.S. market (1.1 trillion euros).
Especially with expectations of prolonged high interest rates, this situation is likely to worsen. The U.S. Federal Reserve (Fed) has signaled a prolonged period of high rates. Fed Chair Jerome Powell said in a speech at the New York Economic Club on the 19th, "Inflation remains elevated," and "additional tightening may be necessary if below-trend growth and labor market easing are not confirmed." This implies that major countries, including Europe, will follow the U.S. in maintaining high interest rates, leading to reduced consumption and investment, lower growth rates, and worsening recessions. Additionally, concerns are spreading over a worst-case scenario where the war triggered by the surprise attack of the Palestinian militant group Hamas on Israel fuels oil-driven inflation, prompting central banks worldwide to raise rates again. When uncertainty expands like this, companies with the lowest credit ratings typically take the hardest hit.
Christian Hantel, corporate bond portfolio manager at Swiss asset management firm Bontobel, analyzed, "Europe's economic situation is definitely worse than that of the U.S. This spread widening can be seen in the context of economic growth slowdown, aggressive rate hikes, and persistent inflation increases." He added, "Triple C corporate bonds are the most vulnerable link connecting demand for high yields and the corporate credit market. It would not be surprising to see this sector face even more stress going forward."
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