Junk Market Flashes Warning as Fed Eyes Higher Rates for Longer

Junk-rated US companies have seen their interest costs rise after the Federal Reserve’s rate-hike campaign, but profits haven’t kept up, putting a squeeze on finances and underscoring a key risk for investors in high-yield debt as the trend persists.

The ratio between companies’ earnings and their interest expense has fallen to the lowest level since the pandemic, signaling they have less income to service their debt. The so-called debt-service coverage ratio averaged just 3.5 times for the median company in the leveraged-loan universe at the end of September, according to Torsten Slok, chief economist at Apollo Global Management, down from more than 5 times a year earlier.

The deterioration is a knock-on effect of the Fed’s months-long campaign to combat inflation by raising its key benchmark rate by some 5 percentage points since 2022. While central bankers reiterated at a policy meeting last week that they expect their next move will be a rate cut, Chair Jerome Powell hesitated to say when reductions would start, noting that the data supported a Fed’s cautious approach.

rate hikes increase coverage risks

Higher-for-longer rates mean borrowers will continue to feel the pinch long after the rate-hike cycle is over. Though the latest debt-service ratios aren’t dire, the expense adds up, and it’s a pressure that can factor into ratings downgrades and even force corporate defaults. Once a company’s debt service coverage ratio falls below 2 times, it often struggles to refinance maturing loans and bonds, said Christian Hoffmann, portfolio manager at Thornburg Investment Management.

“It’s been nearly a year of what’s likely peak rates,” Hoffman said. “As the Fed keeps rates pinned higher, leveraged loan borrowers will continue to feel pain.”