HIGHER-FOR-LONGER RATES ARE A DEBT THREAT. INVESTORS DON´T WANT TO HEAR IT YET. / THE WALL STREET JOURNAL

Higher-for-Longer Rates Are a Debt Threat. Investors Don’t Want to Hear It Yet.

A lull in bond maturities is making markets slow to price in risks in corporate debt, which lurk in unexpected places

By Jon Sindreu

The bonds of the U.K.’s biggest water provider, Thames Water, have sold off on the back of fears that the utility could be nationalized. PHOTO: HOLLIE ADAMS/BLOOMBERG NEWS

There is an old joke: An optimist jumps from the roof and shouts “so far, so good!” when passing the first-floor window. 

Corporate-debt markets are at risk of a similar delusion, particularly where private equity is involved.

Companies will find it expensive to refinance debts they took on during a decade of ultralow interest rates, perhaps more so than expected. 

And, as troubles surrounding British utility Thames Water show, it isn’t always the sectors that investors and ratings firms usually consider risky that are most vulnerable.

The belief that rates will soon start coming back down—despite messages to the contrary from the world’s top central bankers at a meeting in Portugal last week—still pervades the corporate-bond ecosystem.

For one, ratings firms haven’t lowered the grades they give these bonds as a measure of default risk. 

According to S&P Global, debt classified as “investment grade” is still enjoying more upgrades than downgrades. 

Higher-yielding “speculative” or “junk” bonds are being marked down, but less than in 2019.

One reason is that the ground is still a way off: Most of the corporate bonds outstanding today won’t start maturing until 2025, data by S&P Capital IQ shows, as firms used low rates to lock in long-term debt.

“Ratings agencies really find issues when refinance is a year away,” said David Newman, head of global high yield at Allianz Global Investors.

To be fair, as Mr. Newman points out, markets are ahead of raters: The yield spread of corporate bonds over risk-free government equivalents has widened. 

Investors are singling out some beleaguered companies. 

Within speculative BB-rated debt, for example, bonds issued by “The Walking Dead” producer AMC Networks and telecom provider Lumen are trading at spreads that indicate distress. 

Among distressed B-grade issues, well-known names include office-supplies retailer Staples and some of the debt issued by satellite-TV company Dish Network.

Yet, on average, spreads on BB and B-rated bonds are still within recent historical norms. In fact, the high-yield selloff has been almost entirely driven by debt rated CCC or lower.

This suggests that, yes, bond markets are pricing in a mild recession that will drive up default rates among the riskiest firms, and even lead to some blue chips being marked down. Since most investment-grade debt is rated just a notch over junk bonds, this is an unsavory scenario.

What markets may not be pricing in is a new normal of higher rates. 

The surprising resilience of B-rated junk bonds certainly suggests so: Research by S&P Global shows that they are usually hit worst when default expectations materially increase.

A key feature of B-grade paper is that 56% comes from private firms, according to S&P Capital IQ data. 

Amid the bonanza of ultralow rates, particularly in 2021, many private-equity sponsors used it to acquire companies, leaving them more indebted. 

Issuance has now fallen for junk bonds, Dealogic figures show, but not for leveraged loans, which have floating rates and are traditionally the more popular instrument for private-equity buyouts. 

This is another sign that companies are waiting for rates to fall again before issuing more fixed-rate paper. 

If central banks don’t oblige, the extra leverage will weigh. 

This is particularly true of junk-rated private firms, whose bonds tend to be riskier than those of listed corporations according to classic measures of sustainability such as interest cover and debt-to-equity. 

Often, private owners build up debt in order to extract more dividends. 

Private companies can be easier to recapitalize, but there are exceptions, as the crisis that has engulfed the U.K. this past week has shown. 

Thames Water, which has £14 billion, equivalent to around $18 billion, in debt—mostly a legacy of its spell under Australian financial group Macquarie—hasn’t yet convinced its pension-fund and sovereign-wealth owners to inject enough capital. 

Its viability is up in the air after the cost of servicing its inflation-linked debt shot up. Officials are even weighing nationalization.

Some Thames Water bonds that are still rated investment-grade are now yielding roughly in line with B-rated paper.

The case highlights an underappreciated danger stemming from the era of low rates: It isn’t just firms in risky, shrinking markets like satellite TV that may be fragile but also those in sectors usually considered safe, such as water utilities.

For the broader economy, the opaqueness of private markets means that, as these bets go awry, the ripple effects could travel further than expected.

Markets probably realize this. 

But it might not hit investors hard until the 2025 refinancing wave draws closer.