The Potential Iceberg Ahead: U.S. Corporate Debt and Its Implications

The allure of low interest rates led many U.S. companies to load up on debt, protecting themselves from future spikes in borrowing costs. This strategy has paid off in 2023, as the Federal Reserve has aggressively raised its policy rate to its highest level in over two decades.

However, there may be an "iceberg" looming on the horizon if the Fed maintains high rates for an extended period. Concerns about this possibility have already pushed the benchmark rate for the U.S. economy to its highest point since 2007, with the 10-year Treasury yield reaching approximately 4.59% on Friday.

According to Oleg Melentyev's credit strategy team at BofA Global, the full impact of higher rates has yet to be felt, as only a small portion of corporate debt has undergone rate resets thus far. This indicates that what we have witnessed thus far is merely the tip of the iceberg.

Despite the efforts made by the Fed to combat inflation, a significant number of companies are still benefiting from pandemic-era low interest rates. BofA Global reports that only around 10% of the approximately $1.5 trillion U.S. junk bond market has experienced rate resets this year. In comparison, the estimate for investment-grade corporate bonds is around 14%, while the leveraged loan market has seen approximately 13% rate resets over the past year.

Read: A Wrecking Ball Could Hit Leveraged Loans if the Fed Keeps Rates High

High-Yield Bonds Outperform in Challenging Year for U.S. Bond Market

Despite a challenging year for the U.S. bond market, high-yield bonds have emerged as a bright spot. The popular iShares 20+ Year Treasury Bond ETF (TLT) has experienced a significant decline of almost 11% so far this year, while the iShares Core U.S. Aggregate Bond ETF (AGG) is down 3% in 2023, according to FactSet.

In contrast, high-yield total returns have performed well, with Goldman Sachs researchers estimating returns of nearly 6% for the year. Comparatively, 10-year Treasurys have seen negative returns of around -3.4%, and the S&P 500 has advanced by 11.9% (SPX).

Two prominent U.S. junk-bond ETFs, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Bloomberg High Yield Bond ETF (JNK), have also shown positive returns through Friday. HYG has risen by 0.3%, while JNK is up 0.6%, according to FactSet.

While yields have increased across the bond market, credit spreads have remained tight. This suggests that bond investors are not overly concerned about the possibility of a hard landing for the U.S. economy or a severe default cycle. Additionally, potential rate cuts could provide further relief for borrowers facing significant debt maturities in the coming years.