Despite an increasing number of companies defaulting on their debts due to higher interest rates, investors seem to be disregarding this alarming trend. Torsten Slok, chief economist at Apollo Global Management, highlights this concerning behavior in the market.

Rallying Junk Bonds

In the face of rising interest rates and a surge in corporate defaults, U.S. high-yield, or “junk,” bonds have surprisingly been performing well this year. These bonds are often considered a fixed-income proxy for the stock market, rallying during bullish times and plummeting when sentiment turns sour.

Risk Sentiment Challenge

A crucial indicator of risk sentiment shows that U.S. junk-bond spreads are hovering near a 15-month low, standing at approximately 382 basis points above the risk-free Treasury rate. This figure is close to BofA Global’s projection of a trough of 350 to 375 basis points above the benchmark rate.

Typically, investors demand higher spreads as compensation when the economic outlook becomes gloomy or defaults increase. However, this has not been the case in recent months, despite the surge in default rates for both junk bonds and corporate bonds since the Federal Reserve began raising rates in March 2022.

The Moment of Truth

Torsten Slok emphasizes the importance for all investors to assess how high they believe default rates will climb during this cycle. The true “aha moment” in the market is expected to occur when a well-known company defaults, leading to an overnight shift in market sentiment from bullish to bearish.

With these facts in mind, it is crucial for investors to realistically evaluate the risks posed by corporate defaults, even if they seem to be overlooked at present.

The Changing Landscape of Junk Bonds

After a lengthy period of low rates, junk bonds are finally attracting investors with more substantial yields. Currently, U.S. junk bonds are offering an 8% yield, primarily driven by the upward trajectory of Treasury yields caused by the Federal Reserve’s rate hikes.

Similar to many homeowners across the United States, corporate borrowers have taken advantage of historically low pandemic rates to refinance their existing debt. This has limited the impact of higher rates on their financial obligations.

According to BofA Global strategists, only 11% of U.S. corporate bond coupons have reset to higher rates. As a result, “most issuers continue to pay old coupon,” even with the Federal Reserve raising rates by 500 basis points since the previous year.

This trend provides a cushion for numerous high-risk corporate borrowers, even if the Federal Reserve proceeds with its expected rate hike to a range of 5.25%-5.5% on Wednesday.

The Potential Impact of Prolonged Higher Rates

The significant question that arises is pondering the consequences if the Federal Reserve maintains higher rates for an extended period. More companies with maturing junk bonds may face difficulties refinancing their debt.

On Tuesday, stocks were gradually advancing as investors awaited the upcoming Fed decision. The Dow Jones Industrial Average (DJIA) was aiming for its twelfth consecutive day of gains, while the S&P 500 index (SPX) had a year-to-date rally of 19% as of Tuesday, falling roughly 5% short of its record close in January 2022, as per Dow Jones Market Data.

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