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With the Federal Reserve kicking off its cycle of monetary-policy easing with an unexpectedly large rate cut of 50 basis points (bps), corporate borrowers with floating-rate debt and those looking to tap the capital markets will soon benefit. The question is: How soon (and by how much)?

What We're Watching

The Fed's first rate cut since 2020 marked a turning point in the U.S. central bank's battle against persistent inflation, with policymakers shifting their focus to stabilizing a softening labor market. Corporate borrowers that have faced overly burdensome costs of debt service and/or refinancing can now, expect a steady series of rate cuts through the end of next year, at least.

Consistent with our macroeconomic forecasts and our reading of the Fed's guidance, we forecast another two rate cuts this year (of 25 bps each) followed by a total of 125 bps of monetary-policy easing in 2025. That puts our expectations for the terminal rate at 3.00%-3.25% by the end of next year.

However, there are risks to our baseline assumption, including the possibility that that the central bank may front-load its cuts so that the easing may be slower in the spring and beyond as we approach the perceived neutral range—which the Fed pegs at 2.5%-3.5%. This runs the risk of re-igniting the inflationary pressures that policymakers have fought for so long and could increase the odds of a policy correction (i.e., a pause in the easing cycle or, in an extreme case, a reversal).

What We Think And Why

We believe that falling interest rates are more likely to benefit U.S. borrowers in their regular course of business than to be a lifeline for those that would have otherwise failed to refinance. This view is supported by borrowers' robust debt issuance in the past 12 months (when the fed funds rate was at a multi-decade high), which has contributed to longer-dated maturity profiles, needed refinancings, and bolstered capital structures.

Even with a surge in volatility in August (following a tepid U.S. jobs report), the slowing of bond issuance was short-lived. In fact, issuance in the U.S. has surprised on the upside during what is typically a slower period of the year.

Faced with fewer prospects for investment and the rising cost of capital, many U.S. investment-grade issuers with cash to spare have paid down debt to minimize interest expenses. Similarly, many comparatively well-positioned speculative-grade borrowers have refinanced to stabilize their capital structures ahead of any volatility that might arise around the November elections.

Additionally, there's been an increase in the number of companies that couldn't support their capital structures at prevailing rates and were forced to restructure. This has contributed to selective defaults at more than twice the pace we saw prior to the pandemic. These, too, were more likely to emerge with more viable capital structures after companies went through financial reorganizations.

Globally, distressed exchanges are at their highest since 2009, accounting for 82% of defaults in August and 55% of year-to-date defaults. With lower-rated issuers using distressed exchanges to ease near-term debt burdens, this has helped push the default rate higher than its long-term average. However, we expect the pace of distressed exchanges to slow as interest rates decline.

More broadly, S&P Global Ratings expects the U.S. trailing-12-month speculative-grade corporate default rate to fall to 3.75% by June 2025, from 4.6% in June of this year. For now, it seems the default rate peaked in April (at 4.9%). However, the downward trajectory likely won't be as steep as the climb to its recent peak, and our pessimistic case still calls for an elevated 6.25% default rate.

The number of defaults in North America remains elevated at 63 through the end of August, led by consumer products and health care issuers, both higher than where we were at this point last year. Because of growing concerns about the labor market's resilience and increasing delinquencies, consumer-facing sectors continue to be among the most vulnerable and among those that are most likely to lead defaults.

A steady descent in benchmark interest rates (and, presumably, all-in borrowing costs) makes capital more accessible and may render once-abandoned investment opportunities viable again. A key risk in the next few quarters regards the resilience of the U.S. labor market—which has been so critical in propping up consistent consumer demand.

What Could Change

Financial markets seem especially vulnerable to negative news amid fears that the eventual slowdown in U.S. GDP growth will be sharper than expected. After nonfarm payrolls data for July fell short of economists' forecasts—along with unemployment rising and wage gains shrinking—speculative-grade bond spreads in the U.S. widened sharply.

In fact, within a week's time, speculative-grade spreads widened 27%, to 315 bps on Aug. 5— near the record pace of March 2020 at the onset of the pandemic and well above the all-time low of 229.6 bps in early May.

While U.S. corporates have made progress in reducing upcoming maturities so far this year (as of July 1 there remained $287.9 billion of speculative-grade debt maturing through 2025, of which 31% is rated 'B-' and lower), some of these borrowers may suffer liquidity strains. This is particularly true if investors begin to demand significantly higher returns for the risks they're assuming and market volatility picks up.

As the U.S. election approaches, we could see increased risk-aversion among investors, especially given how tight the presidential race is, according to most polling. If the result of the run for the White House is unclear or in dispute, financial-market volatility could roil credit conditions.

On the flip side, if the world's biggest economy continues to outperform expectations or inflation returns, the central bank could keep its key rate higher than markets anticipate. In either scenario, financing costs could remain overly burdensome for some borrowers, especially those at the lower end of the ratings spectrum.

Writers: Joe Maguire and Molly Mintz