As the Fed Raises Rates, Worries Grow About Corporate Bonds

As the Federal Reserve raises interest rates in an effort to tame inflation, the corporate bond market, which lends money to many companies, has been hammered particularly hard.

The steep rise in interest rates has caused bond values to tumble: From October 2021 to October 2022, an index that tracks investment-grade corporate bonds is down by roughly 20 percent. By some measures, overall bond market losses have been worse than at any time since 1926.

The yield on bonds issued by solid businesses is now about 6 percent, about twice as much as it was a year ago. That number indicates how high of an interest rate rock-solid corporations would have to pay to borrow more money right now; rates are even higher for smaller businesses or those that investors consider risky.

Corporate bankruptcies and defaults remain low by historical standards, but a growing number of companies are struggling financially. Businesses in industries like retail, manufacturing and real estate are especially vulnerable because their sales are weak or falling. In many cases, their customers have also been hurt by higher interest rates because the higher borrowing costs have effectively raised the costs of big-tickets items like homes and cars.

Until recently, for example, Carvana was a fast growing used car retailer with a soaring stock. The number of cars the company sold fell 8 percent in the third quarter, and its spending on interest payments tripled compared with the same period a year earlier. The interest rate on a big chunk of its debt issued this year that matures in 2030 is 10.25 percent. Its bonds are trading at less than 50 cents to the dollar, suggesting that investors would require Carvana to pay an interest rate of nearly 30 percent if it were to borrow more money for the same amount of time. The company’s stock is down more than 90 percent over the last year.

“There’s certainly a lot of headwinds,” Ernest Garcia III, Carvana’s chief executive, said on a conference call with analysts last week. “Recently, we’ve seen car prices depreciate to the tune of give or take 10 percent so far this year, but we’ve also seen interest rates shoot up very rapidly and I think that overall has harmed affordability,” he added, even as he expressed optimism about the company’s ability to weather the financial storm.

Before rates jumped, companies borrowed a ton of money last year, with lower-rated firms selling more new bonds in 2021 than in any other year. But that flow has turned into a trickle as interest rates have risen and investors have grown more discerning about whom they lend money to. Banks are still making more commercial and industrial loans, but they are also becoming more discerning and are charging higher interest rates.

Most investors, executives and economists expect a recession or anemic growth next year, which could make doing business, borrowing money and paying off loans even more difficult.

The looming question is, how many businesses are likely to buckle under those strains and what impact that could that have on the economy?

Moody’s, the credit rating agency, said general borrowing conditions for companies would remain “adverse” in the first half of 2023, with default rates climbing because of higher borrowing costs along with the strain of inflation and weakening demand. If inflation substantially eases early next year, Moody’s said it would expect the Fed to pause its rate hikes by midyear.

In what Moody’s calls its “moderately pessimistic scenario,” the default rate among corporate bonds below the top tier “investment-grade” rating will climb to 7.9 percent in September 2023 from 2.3 percent in September of this year, well-above the historical average. That could lead many companies to file for bankruptcy and lay off workers.

Retail companies with already-high debts and expensive leases are some of the most vulnerable businesses in corporate America, according to CreditRiskMonitor, a research firm.

A few well-known businesses are already in financial trouble. Revlon, the cosmetics company, filed for bankruptcy protection in June after amassing a debt of $3.8 billion. The company is facing stiff competition from newer cosmetics brands and has struggled with the debt it took on to pay for mergers and acquisitions.

Analysts are concerned about the financial problems of several other household brands. They include Rite Aid, which borrowed a lot money to buy a pharmacy benefit manager in 2015, and has been closing dozens of stores even as it seeks to increase sales at the outlets it still operates.

Another is Bed Bath & Beyond, which has struggled to compete with online retailers and to keep ahead of changing consumer tastes. That retail chain is projected to closed about 150 of its stores and cut 20 percent of its corporate and supply chain staff. It has a debt of more than $1 billion. On Wednesday, the company said it had reached a deal with some investors to convert a portion of its debt into shares.

Executives at both companies have said that their turnaround plans are working.

Heyward Donigan, the chief executive of Rite Aid, has emphasized “good progress on key initiatives,” including a rising number of prescriptions filled and a reduction in some expenses. And Sue Gove, the chief executive of Bed Bath & Beyond, said in a recent statement that the company was “confident that our current liquidity will enable the necessary changes we are implementing.”

There are other signs of stress. After a sharp increase during the pandemic, the number of new businesses being established in the United States has plateaued this year. The housing market has slowed sharply and some companies like Meta and Twitter are laying off thousands of workers.

If the Fed keeps raising rates and weaker companies begin to fail or struggle, relatively healthy companies could find it harder to borrow money because investors will begin to worry who will be hit next. Even if the number of failures is relatively small, it “can have a cascading effect,” said Joe Quinlan, the head of market strategy for global wealth and investment management at Bank of America.

“The herd gets moving in one direction and that can create its own problems,” Mr. Quinlan said.

Still, many Wall Street analysts said they were not worried, pointing to a variety of indicators that they said showed businesses getting through the next year or two mostly unscathed.

The New York Federal Reserve compiles a Corporate Bond Market Distress Index that aims to measure the overall health of the market, with a higher number suggesting more distress. The index is currently at its highest level since late 2020, but it is far below where it was early in the pandemic and during the 2008 financial crisis.

Analysts who believe that businesses will be mostly fine note that U.S. households overall have only used up about one-quarter of the $2.3 trillion in extra savings they accumulated during the pandemic, which suggests that demand for goods and services should stay robust. Also, many companies have a lot of cash on hand from when the economy was stronger and interest rates were lower, which should reduce or eliminate their need to borrow money for the next couple of years.

Maureen O’Connor, the global head of high grade debt at Wells Fargo, noted that many companies don’t have a “gun to their head on refinancing,” despite a corporate financing environment that appears terrible.

Brian Funk, the head of credit research for MetLife Investment Management, added that conditions were better than they might seem for even riskier companies that have taken out “leveraged loans” — a form of debt that has floating interest rates that adjust every so often, meaning that those rates can increase sharply and have moved higher for debt issued before the recent jump in rates.

“There is a huge, huge difference in the underlying costs of capital now,” Mr. Funk said. “The good news is that the shift doesn’t, in my view, translate to defaults right away because the refinancing needs in the leveraged loan space are fairly benign in 2023 and they really don’t kick in until 2025 and beyond.”

David Del Vecchio, a managing director at PGIM Fixed Income, also does not think that there is much reason to fret or panic for now, but he acknowledged that it was always hard to predict exactly where financial strains would show up and when.

“The fragilities of the market, and pinpointing them, are really, really difficult,” said Mr. Del Vecchio. “And it’s always a surprise.”

Joe Rennison contributed reporting.