Riskiest Credit Corner Shrugs Off Crisis-Era Borrowing Costs

(Bloomberg) -- As short-term borrowing costs swell to levels last seen in the financial crisis, the underbelly of credit markets shows investors are sanguine about the fortunes of Corporate America as the post-crisis stimulus era wanes.

Just look at the signals from the high-yield market.

The riskiest U.S. companies are outperforming their higher-rated counterparts, defying the triple threat of rising short-term dollar borrowing costs, benchmark 10-year Treasury yields at four-year highs and elevated equity volatility.

Case in point: CCC rated bonds are in the green so far this year, returning 44 basis points, outperforming higher-rated counterparts and the broader index, data compiled by Bloomberg show.

"Surprisingly, CCC rated bonds have outperformed the high end of HY despite the higher volatility regime since early February," notes Goldman Sachs Group Inc. strategist Lotfi Karoui, recommending BB rated notes for their better value.

And a key metric suggests the backdrop for corporate risk now looks more challenging.

The three-month London interbank offered rate, referencing trillions of dollars of financial contracts, has surged to the highest since December 2008 amid rising Treasury yields. And its spread with the Overnight Index Swap rate -- a companion gauge of bank-funding stress -- is near 2016 highs thanks to shifts in U.S. fiscal and monetary policies.

To UBS Group AG, the strong showing for risky U.S. debt in this climate shows investors are betting access to corporate funding won't be compromised as post-crisis monetary conditions normalize.

"At the moment, investors believe growth and earnings are good enough to prevent default," said Stephen Caprio, credit strategist at the Swiss bank. “Recession risks remain very low.”

It's a case of pain postponed.

With $2.2 trillion in floating-rate obligations -- loans that adjust upward with interest rates -- more than four Federal Reserve interest-rate increases would spur notable funding strains in the speculative-grade market, according to UBS.

For now, the firm recommends investors adopt a defensive posture in their credit allocations as higher rates challenge corporate debt-servicing capacity in the coming quarters.

"Interest coverage ratios are very weak for B and CCC rated HY credit, comparable to 2001 levels, and earnings haven't fallen yet," Caprio said. "Some of these names have fixed-rate debt rather than floating, so it takes time for higher Fed rates to impact capital structures -- but it's still a risk."

To contact the reporter on this story: Sid Verma in London at sverma100@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Joanna Ossinger, Andrew Dunn

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