Special Encore: Vishy Tirupattur: Corporate Credit Risks Remain

Original Release on August, 1st 2023: While the U.S. economy appears on track to avoid a recession, investors should still consider the implications of an upcoming wave of maturities in corporate credit.

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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, I will be talking about potential risk to the economy. It's Tuesday, August 1st at 10 a.m. in New York.

Another FOMC meeting came and went. To nobody's surprise the Fed hiked the target Fed funds rate by 25 basis points. Beyond the hike, the July FOMC statement had nearly no changes. While data on inflation and jobs are moving in the right direction, the Fed remains far from its 2% inflation goal. That said, Fed Chair Powell stressed that the Fed is closer to its destination, that monetary policies is in restrictive territory and is likely to stay there for some time. Broadly, the outcome of the market was in line with our economists expectation that the federal funds rate has peaked, will remain unchanged for an extended period, and the first 25 basis point cut will be delivered in March 2024.

Powell sounded more confident in a soft landing, citing the gradual adjustment in the labor market and noting that despite 525 basis point policy tightening, the unemployment rate remains at the same level it was pre-COVID. The fact that the Fed has been able to bring inflation down without a meaningful rise in unemployment, he described as quote unquote "blessing". He noted that the Fed staff are no longer forecasting a recession, given the resilience in the economy.

This specter of soft landing, meaning a recession is not imminent, is something our economists have been calling for some time. This has now become more broadly accepted across market participants, albeit somewhat reluctantly. The obvious question, therefore, is what are the risks ahead and what are the paths for such risks to materialize?

One such potential risk emanates from the rising wave of credit maturities from the corporate credit markets. While company balance sheets, by and large, are in a good shape now, given how far interest rates have risen and how quickly they have done so, as that debt begins to mature and needs to be refinanced, it will happen at sharply higher rates. From now through the end of 2024, almost a trillion of corporate debt will mature. Sim ply by holding rates constant, that refinancing will represent a tightening of financial conditions.

Fortunately, a high proportion of the debt comes from investment grade borrowers and does not appear to be particularly challenging. However, below investment grade debt has a tougher path ahead for refinancing. As we continue through 2024 and get into 2025, more and more high yield bonds and leveraged loans will need to be refinanced.

All else equal, the default rates in high yield bonds and leveraged loans currently hovering around 2.5% may double to over 5% in the next 12 months. The forecasts of our economists point to a further slowdown in the economy from here, as the rest of the standard lags of policy are felt. We continue to think that such a slowing could necessitate a re-examination of the lower end of the credit spectrum. The ongoing challenges in the regional banking sector only add to this problem. In our view, in the list of risks to the U.S. economy, the rising wave of maturities in the corporate debt markets is notable.

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