Weak Companies’ Low-Yielding Bonds Set to Hit Maturity Wall

Wall Streeters call it the “maturity wall,” and it is daunting: In 2024, $38 billion in junk bonds are due to mature, and that mounts rapidly to $235 billion in 2028, according to Bloomberg statistics. Trouble is, these corporate bonds were floated during the low-interest-rate era, which ended last year when the Federal Reserve began raising interest rates to combat inflation.

Many bond issuers are vulnerable: “Zombie companies are ‘alive’ and are multiplying—they are highly sensitive to surging borrowing costs,” warned a BCA Research report.

An estimated 10% of U.S. companies—zombies, if you will—cannot cover their interest expenses with operating cash flow and have been getting by thanks to more borrowing, a Federal Reserve study found. Nowadays, of course, added borrowing is tougher to do, with higher rates. The number of corporate bankruptcy filings has risen to 324 through September, per S&P Market Intelligence, a level not seen since 2010 and the aftermath of the financial crisis.

The high-yield corporate bond default rate is on the rise, now at 3.7%, up from 1.5% six months ago. S&P Global Ratings expects defaults to rise to 4.5% by mid-2024. S&P downgrades this year are almost twice the number of upgrades, LPL Financial reported, making 2023 the worst year for downgrades since pandemic-spooked 2020.

The living-dead bond issuers—mainly companies rated below investment grade—could not resist the low rates that prevailed before 2022. Now they face refinancing at levels three to four times their previous yields. “Companies gorged on cheap debt in 2020 and 2021,” observes Harley Bassman, a managing partner at Simplify Asset Management and creator of the MOVE Index, the standard measure of interest rate volatility. “The Fed’s medicine has poisoned the system.”

This leaves allocators in an uncomfortable position: Some of their bond positions may be headed into a ditch. “Institutions will have to grapple with [bond issuers] refinancing at higher costs,” says Jim Schaeffer, global head of leveraged finance at Aegon Asset Management.

Bank lending to highly indebted companies, known as leveraged loans, also are burdensome, although any reckoning for borrowers appears to be superseded by that of bonds, which are maturing sooner. (Lev loans are a big weight on weak companies, however, because the interest rates are floating and have already increased since 2022.)

Assuming rates continue to climb, another vexing problem for bondholders concerns duration, says Henry Greene, an investment strategist at asset manager KraneShares—rising rates are no friend to bond prices. Junk has an average duration of four, which means a one-point hike in rates would decrease prices by 4%. “A squeeze would happen,” says Garry Evans, BCA’s chief global asset allocation strategist.

Judgment Day Ahead

One notable recent example is Takko GmbH, a German discount fashion retailer, which went deep into debt to get through the pandemic. The upshot was a change in control of the company, with creditors taking over—a possible precursor of what may lie ahead in the U.S.

In August, bondholders and lenders swapped their $400 million in Takko debt, due in 2023, for majority control of the 2,000-store chain’s equity. The restructuring agreement also involved refinancing and extending $294 billion in bank loans to 2026. (Bank loans are more important than bonds in European corporate finance.) Before the restructuring, S&P Global Ratings gave Takko a deep junk CC rating. The company now is unrated; it could not be reached for comment.

Currently, any trouble for junk bonds in the U.S. has yet to hit with full force. Better-than-expected economic news has, for now, buoyed speculative bonds by keeping cash flow going. The Bloomberg high-yield index, down 11.2% in 2022, is ahead 6.9% thus far this year. Other indicators show that investors are not very worried about junk. The credit spread between Treasury and junk bonds still is on the low end at 4.1 percentage points, St. Louis Fed’s data show.

From an investors’ standpoint, the rewards of owning speculative-grade bonds are obvious. Junk yields now average around 9%, per BCA. That is almost double what the benchmark 10-year Treasury bond pays. Some high-yield paper yields in the low teens. But to critics, the continued popularity of junk is absurd, given the looming maturity wall and other signs of trouble.

The “high-yield market has lost its mind,” wrote Lawrence Gillum, chief fixed-income strategist at LPL, who marveled that junk bonds have done so well despite rising defaults and downgrades.

Steering Through Trouble

The keys to navigating this rocky terrain are those old standbys of asset managers, diversification and judicious selection. Andrew Grant, director of manager research and investment solutions at Kayne Anderson Rudnick, which provides investment strategy advice to allocators, says his clients have “massive diversification,” with no more than 1% of their portfolio tied to any single borrower.

This situation presents “some opportunities” for distressed investors, notes Christopher Ailman, CIO of the California State Teachers’ Retirement System (assets: $308 billion). While CalSTRS itself may or may not embark on this vulture investing, Ailman has made sure to include junk bonds in the fund’s portfolio—around 5% of its holdings. One-third is managed in-house, and the rest by outside managers.

Like most allocators, CalSTRS is hardly making any big, near-term changes in its asset allocation, insisting it is a long-term investor satisfied with the seaworthiness of its portfolios for all types of weather.

Is Ailman worried that his high-yield bonds will sour? “We don’t take outsize risk” with them, he says. CalSTRS does not have a lot of fixed income, just 10.5% as of September 30. As “rates will stay higher for longer,” Ailman says he intends to pump up the overall bond allocation to 14%, although it is unclear what the ratings will be on those additions.

If allocators do want to shift assets to better insulate themselves from defaults, downgrades and other calamities, “this is a good time to move up in quality,” says Fran Rodilosso, head of fixed-income ETF portfolio management at fund manager VanEck Associates. To him, that means mostly investment grade, although he includes BB, the highest junk tier.

Listening to the Fed leaves one central message: Interest rates will be higher for longer. Fed Chair Jerome Powell has made clear that the central bank has returned rates to, in his view, their regular level (meaning in mid-single digits, where they reside now), and has no intention of backing off that conviction. Evidently, only a recession—which many investors anticipated last year but now are less worried about—would change the equation.

A recession likely would convince the Fed and bond traders that rates should drop, likely not to the old near-zero vicinity, but maybe by a point or so. Then, as KraneShare’s Greene points out, “rates might mean-revert” and maybe even go below 10-year Treasury yields. Such a development would be a respite for junk issuers whose maturities are approaching.

That would be a two-edged sword for junk issuers. Cash flows shrivel in a recession—but at least their refinancings would be less onerous.