Stagnation casts a shadow over the credit market: Premiums for CCC-rated bonds soar to a 14-month high.

With the increasing concerns about stagflation caused by the Middle East conflict, global investors are showing significant risk aversion towards high-risk borrowers, especially those vulnerable companies that have accumulated a large amount of cheap debt in the era of ultra-low interest rates. Data shows that global investors currently require an additional yield of about 6.4 percentage points for holding CCC-rated high-risk bonds, reaching the highest premium level in the past 14 months. At the same time, credit funds are preparing for potential increased pressure in the high-risk loan and private credit sectors, involving leveraged buyout debts of up to $2 trillion. The conflict in the direction of Iran has been ongoing for over three months, and the rise in oil prices further exacerbates the pressure on highly indebted borrowers. The blockage of the Hormuz Strait has been pushing up inflation for a long time, which may lead to high interest rates being maintained for a longer period, thereby dragging down economic growth. Lower-rated companies are the most vulnerable as their financing capabilities are far lower than their higher-rated peers. Mitch Reznick, head of fixed income at Federated Hermes in London, managing over $90 billion in assets, said, "If the transition from deflation to reflation ultimately evolves into stagflation, companies will face a 'vicious combination' of declining operating cash flows and rising capital costs. This poses an extremely severe challenge for highly leveraged companies." The differentiation within the U.S. leveraged loan market is also very apparent. Data shows that loans with a composite rating of CC saw an 8% decline in returns this quarter, while BB-rated loans recorded a positive return of 1.4%. Holly Kim, co-founder of hedge fund Glendon Capital, said at the Bloomberg Global Credit Forum in New York, "Whether we are heading into a recession or not, we will experience a default cycle." This is closely related to the accumulated debt from leveraged buyout bubbles in 2021-2022. The forum's on-site survey also showed that "stagflation" was seen by participants as the biggest risk in the credit market. However, some credit investors remain optimistic about companies' ability to cope with higher financing costs. The yield spread on U.S. junk bonds recently approached a 20-year low reached in January. These bonds globally offer an average yield of about 7% with a shorter duration, making them relatively less sensitive to government debt rate movements. It is worth noting that market differentiation is deepening. Goldman Sachs data shows that the spread on interest rate adjustments in the U.S. dollar market has reached near the highest level since the global financial crisis. Strategists, including Amanda Lynam, pointed out that the resilience of BB-rated debt reflects a "pursuit of quality," attributing this to geopolitical and macroeconomic uncertainties. From a global perspective, the spread between CCC and BB credit spreads is currently about five times higher than in more than a decade. Since the beginning of the year, the spread compensation for global BB-rated corporate bonds has narrowed, while the yield premium for CCC-rated bonds has expanded by 86 basis points. B-rated debt has also underperformed the overall market. David Forgash, head of leveraged finance at Pacific Investment Management Company (PIMCO), said, "The high-yield market is showing a high degree of differentiation." He warned that the speculative-grade market "feels somewhat complacent," as the need for higher spread debt is "hidden beneath the surface of narrow spread products." PIMCO also pointed out that the decade-long prosperity has fostered reckless underwriting in the private credit space, and direct lending is facing pressure as it focuses on software companies impacted by artificial intelligence. UBS Group strategist previously warned that if artificial intelligence triggers a dramatic disruptive change among corporate borrowers, the default rate in the $1.8 trillion private credit market could surge to 15%. Reznick of Federated Hermes added that consumer-facing companies are under intense scrutiny, and the market may not fully reflect their risks. He tends to choose higher-quality credit assets: "It is now advisable to slightly steer clear of highly leveraged companies with risks to consumers. Currently, the risks taken for returns are not sufficient to compensate for the irreversible losses once a mistake is made." He also pointed out that if the Hormuz Strait remains closed, Europe may be more vulnerable to stagflation shocks than the U.S. Raphael Thuin, head of capital market strategy at Tikehau Capital in Paris, stated that in Europe, the chemical, packaging, automotive parts, and real estate industries are generally under pressure this year. "Industries affected by tariffs, energy prices, or competition from China tend to see significant discounts."