U.S. high-yield corporate debt markets may be underpricing for the risk of a recession even as Treasuries and macroeconomic indicators reflect rising growth fears, but that may be tested soon with corporate earnings projected to worsen.
Leveraged loans and high-yield corporate bond prices have fallen from record highs reached early this year as rates increase and their spreads over benchmark rates widen, but they still reflect a relatively rosy economic outlook.
“Credit spreads are too tight, they are not adequately reflecting the risk of recession. Other models that we use, whether it’s the yield curve or the macro-economic hard data are more bearish,” said Matthew Mish, head of credit strategy at UBS, adding that at some point “these need to converge.”
UBS said that spreads on high-yield, or “junk,” bonds and leveraged loans imply recession odds of 25-30%, while other models show a 55% probability of a downturn. Leveraged loans and junk bonds are high-risk corporate debt.
Loans typically having floating rate payments and a secured claim on a company’s assets in a default, while bonds are unsecured and often have fixed rates. Their borrowing rates have been held in check by solid liquidity while default rates are near historical lows and not seen likely to spike significantly near-term.