Rumblings of distress are working their way through the U.S. economy in ways not seen since the early days of the pandemic.

The amount of distressed debt among U.S. companies in May rose to $49.2 billion, nearly doubling the April figure of $25.8 billion, according to S&P Global Ratings. Ratings defines distressed debt as speculative grade debt with option-adjusted spreads (which use pricing models to discount a security’s payments to match its market price) of more than 10% above U.S. Treasury yields.

The rise in distressed debt contributed to an unusually high increase in the distress ratio, an early warning sign that more defaults are likely. The U.S. distress ratio (calculated by dividing the amount of distressed debt by the total amount of speculative grade debt) was 6.4% as of June 27, up from 4.3% in May, according to Ratings. The U.S. distress ratio in May reflected the highest month-over-month change since March 2020, at the start of the COVID-19 pandemic.

That is still lower than the five-year average of 7.5% from 2018 to 2022. But default figures generally reflect swings in the distress ratio, so the big rise in the distress ratio makes more defaults more likely.

"If we continue to see this increase at the pace it is now, I think we will begin to worry, especially when it starts to get above that five-year average mark," said Nicole Serino, associate director of credit markets research at Ratings.

Demands rise

Until May, the distress ratio had been more stable, despite widening spreads of speculative grade debt and increased credit market volatility. Now, though, investors wary of hot inflation, rising rates and the possibility of a recession are demanding higher premiums for riskier debt.

Spreads on B-rated debt widened 26% from the beginning of the year to June 13, according to the latest figures from Ratings, and CCC spreads widened 41% in the same period. U.S. speculative-grade and investment-grade secondary market credit spreads are at their widest since the beginning of 2021, Ratings said in a June 27 report. Both were above their five-year averages as of June 24.

With the Federal Reserve tightening monetary policy and with pandemic stimulus measures receding in the rearview mirror, restructuring professionals say they are getting more calls from businesses and banks looking to prepare for what many consider an inevitable downturn in the economic cycle.

"Everybody's seeing certainly more conversation about what to do about the oncoming problems as the companies run out of liquidity because the government money [is running out], as the interest rates are going up and as they're not able to pass through some of the cost increases," said David Weinstein, managing director of CohnReznick's restructuring and dispute resolution team.

Retail woes

The sector with the highest distress ratio as of June 3 was retail and restaurants at 15.9%, up from 4.5% in April. Consumer industries are often the first parts of the economy impacted when market stress begins to increase. Short interest in consumer discretionary stocks rose at the end of May, and U.S. retail sales declined in May by a seasonally adjusted 0.3%.

Restaurants and retailers appear to be struggling with high inflation, which is increasingly harder to pass on to consumers, and their profitability is under pressure from rising supply chain costs and wages, said David Berliner, a BDO USA LLP partner who leads the company's restructuring and turnaround services practice.

"Post-pandemic you're seeing the seesaw switch for companies that benefited during the pandemic," Berliner said.

The sectors with the next highest distress ratios were health care at 11.4% and aerospace and defense at 11.1%.

Oncoming train

Although a rise in the distress ratio has usually foreshadowed an increase in default rates, many large U.S. companies have stable outlooks and strong balance sheets. The low amount of defaults and bankruptcies suggests that waves of failures are not imminent — but market disrupting events are rarely foreseen.

"You can't see the train coming," said Dan Dooley, principal and CEO of MorrisAnderson. "You only see it after it hits you."

Broader distress could be limited if the government steps in as it has in the past to assist businesses and consumers. In previous downturns hedge funds and private equity firms have had more opportunities to take advantage of other people's financial woes, but it will take a while for such distress to make its way through the system.

"It's still early days," said Mark Lichtenstein, a bankruptcy and reorganization partner at Akerman LLP.