The Federal Reserve's hint that it may impose higher-for-longer interest rates threatens to push up defaults as companies with debt maturing as late as 2025 face potentially higher refinancing costs.

Fed Chairman Jerome Powell's comments on March 7 that the central bank is prepared to raise interest rates even faster if economic conditions warrant it fueled fears that rates, which have already climbed at the fastest pace in decades, will go even higher and stay there for longer. While markets are betting the recent failures of Silicon Valley Bank and other banks will keep the Fed from raising rates further, inflation remains stubbornly high with consumer prices rising 6% year over year in February.

S&P Global Ratings forecasts that costlier financing from higher rates and weaker corporate earnings will increase the 12-month trailing default rate of non-investment-grade rated companies to 4% by December, up from a historically low 1.7% at the end of 2022. The forecast is predicated on a mild, shallow recession later this year, though a deeper-than-feared downturn and higher interest rates could see that default rate hit 6%.

"I don't think you're going to see interest rates falling straight away, so the duration and extent of that decline is the real risk," said Nick Kraemer, head of ratings performance analytics at S&P Global Ratings.

Markets movements

Investors rushed to the credit default swap market in 2022 as a way to protect against the threat of rising defaults as the Fed raised rates from near-zero to a range of 4.25-4.5% by year-end. Meanwhile, liquidity in bond markets dried up, with issuance collapsing as the cost of corporate borrowing rose sharply. The yield on the S&P U.S. High Yield Corporate Bond Index, for example, climbed from 4.2% at the start of 2022 to 8.76% on March 8, 2023, with an 11-basis-point increase following Powell's comments to Congress.

"It was the news investors didn't want to hear but deep down had a sneaky suspicion would come," said Russ Mould, investment director at AJ Bell. "Powell made it perfectly clear that U.S. interest rates would keep going up, potentially faster and harder than markets had previously priced in."

BBB-rated companies, which account for more than 20% of the companies covered by Ratings, face particular threats from spikes in high-yield borrowing costs as they sit just one notch above that speculative-grade pool. The increase in borrowing costs between investment-grade and high-yield companies can be sharp, owing to the higher perceived risk of the debt and the reduced liquidity in the high-yield space.

The yield on the S&P U.S. Investment Grade Corporate Bond BBB Index was 5.87% at the close of March 8, almost 300 bps lower than the high-yield index.

Stars and angels

The BBB space has expanded in recent decades amid a general reduction in the credit quality of U.S. corporations as low interest rates facilitated a buildup in leverage.

So far in 2023, the number of fallen angels — companies that have been downgraded to high-yield from investment-grade — has been outpaced by rising stars going the other way.

"The investment-grade companies in particular took out so much debt in 2021 and a lot of that is parked as cash on their balance sheet and fixed rate," Kraemer said.

Ratings expects more fallen angels this year, with a forecast rate of 2.5% of investment-grade companies falling into the high-yield category as the economy slips into recession and balance sheet pressures build.

"At some point, there will be an investment-grade downgrade story, but that's more a story for the second half of 2023," said Viktor Hjort, global head of credit strategy for French bank BNP Paribas.

Default wave, not crisis

Were the default rate to hit the 6% forecast by Ratings, the number of speculative-grade defaults would be relatively mild compared to the roughly 12% rates during the Great Recession or the aftermath of the bursting of the dot-com bubble in the early 2000s. Corporations took advantage of ample liquidity provided by the Fed during COVID-19, with record bond issuance to refinance debt at a lower cost and longer maturities.

BNP Paribas forecasts a default rate of 5% in 2023 that will persist through 2024 if interest rates stay elevated.

"That qualifies as a wave of defaults, not a crisis," Hjort said.

Much will depend on how well consumer spending holds up as a drop in earnings could quickly make corporate balance sheets look less healthy.

"A year ago corporate fundamentals were good and you had COVID-19 buffers," Hjort said. "Fast forward a year and those buffers have not been entirely depleted, but they are nowhere near as strong."