Deutsche Bank strategists warn that the delay in Federal Reserve rate cuts is likely to increase borrowing costs, placing more pressure on U.S. companies.

While default activity has so far been confined mainly to distressed debt exchanges with relatively high recovery rates, this is partly due to hopes for a soft economic landing. Persistent inflation, policy uncertainty, and rising sovereign bond term premiums are undermining these hopes.

Increased Risk for Speculative Grade Issuers

The bank anticipates that speculative-grade issuers face an increased risk of default. They forecast a possible rise in the default rate to 5.5% by mid-2026, which would be the highest issuer-weighted default rate for lower-rated U.S. corporate debt since 2012.

This analysis points firmly towards a broader credit deterioration risk over the medium term. What Deutsche’s team is laying out is a road map where borrowing expenses keep rising, driven by a central bank that remains cautious in reducing interest rates. The longer the Federal Reserve holds out, the more weight that builds on corporate balance sheets—particularly for firms with weaker credit profiles.

So far, default events have been skewed towards distressed exchanges. Those are situations where companies renegotiate debt terms under pressure but can still offer creditors relatively decent recoveries. That doesn’t necessarily mean these firms are healthy—it reflects efforts to buy time rather than a full-blown collapse. Such outcomes have kept recovery rates from tumbling. But these more favourable outcomes depend heavily on perceptions that the economic downturn will be shallow and short-lived. If we move away from that scenario—and inflation stays warm, policy shifts remain unpredictable, and yields on U.S. Treasuries continue climbing—those assumptions start to crack.

Blickenstaff and his team aren’t casual with their forecast. A 5.5% default rate doesn’t arrive suddenly; it’s the result of months or even quarters of steady erosion in liquidity, refinancing capacity, and profit margins. For perspective, this would represent the steepest rate of defaults for low-rated corporate borrowers in over a decade.

Impact of Rate Trajectories on Corporate Decisions

As we assess this environment, our approach must factor in the wider mechanics at play. Higher term premiums on government bonds suggest investors are demanding more compensation for holding longer-dated debt. That increase in yields functions like an unspoken rate hike – tightening financial conditions without any policy move from the Fed. When benchmarks reprice this way, downstream effects trickle into all credit markets, making refinancing risk a more active threat.

For our positioning, the focus should be squarely on time horizons and survivorship. In a market where tailwinds from central bank easing are not arriving when anticipated, names that built their capital structures on refinancing assumptions may quickly find spread widening erodes any residual optimism. Careful screening of leverage ratios, cash flow buffers, and maturity walls is no longer optional—it’s foundational.

Rate trajectories are not just theoretical constructs; they influence real decisions about rollover, issuance, and default probability. The pressure is not equal across all issuers, either. Those further down the rating scale—think CCC and below—tend to feel this tightening cycle faster and more acutely. Their risk premia balloon quicker. Their access to capital evaporates sooner. What might have seemed like a manageable coupon in 2021 can now morph into an insurmountable hurdle.

In adjusting our strategies, it’s critical we do not treat the coming quarters as an extension of 2023’s relative calm. Debt costs are biting into margins. For some firms, the next callable date could be a lifeline or a cliff. The distinction often hinges on one variable: whether the door to funding is cracked open or already shut.

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