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(Bloomberg) — The strong US economy has left distressed debt investors starved of opportunity but that may be about to change, according to veteran high-yield analyst Marty Fridson.  

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The latest Federal Reserve survey of senior loan officers showed banks raising standards by the most in three years when they’re lending to medium-sized and larger companies. That’ll put the squeeze on borrowers already grappling with higher funding costs and global volatility from escalating trade wars. 

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“At the margin, a tightening of credit standards puts more companies in serious risk of default,” said Fridson, a former strategist at Merrill Lynch whose debt analysis has been studied by Wall Street for decades.

Risky borrowers are having to refinance at higher interest rates as cheap Covid-era debt facilities start to expire. Despite the Federal Reserve starting to cut rates in September, borrowing benchmarks such as the 10-year Treasury yield have risen since then, leaving junk-rated firms more vulnerable to a downturn that would hurt their earnings and lead to job cuts, denting the wider economy.

There’s a correlation of about 0.7 between lending standards and the level of distress in credit markets, Fridson’s data going back to 1997 show. The distress ratio — the proportion of bonds trading at a spread of 1,000 basis points or higher — fell to 3.7% in January, well below the 12.7% historical average, and down from a recent peak of 10.4% in March 2023.

“You’re not going to see the distress ratio zoom up immediately, but it will go up,” said Fridson. When the distress ratio was at a record high of 82% in November 2008, credit availability was at its worst ever, the chief executive officer of Fridson Vision High Yield Strategy said. 

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Of course, the latest Fed survey data may just be a blip — lending standards have been in decline since September 2023 and could loosen up again if banks see beyond trade war volatility and get confident that the US is on a sustainable long-term growth path. Other tailwinds include ample global demand for yield from US issuers and private markets, where there’s a lot of dry power available that offers a lifeline to some struggling borrowers.

Refinancing Costs

But the biggest move up in lending standards since the fourth quarter of 2022 adds pressure to the weakest companies with nearby debt maturities. For some, refinancing costs are unsustainably high, just as new trade and immigration policy threaten to put pressure on input costs and therefore earnings, making debt markets less predictable.

Hear Lotfi Karoui, Goldman Sachs chief credit strategist, discuss hedging strategies  

At the same time, corporate bond spreads remain close to the pre-financial crisis tights they hit last year. The narrow gap between risk premiums on notes of different credit quality highlight the fact that there is much more demand for high-yielding debt than net new supply.

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The distress ratio staying low for a protracted period is “a tinderbox waiting to explode,” Phil Brendel, senior credit analyst at Bloomberg Intelligence, said in a recent podcast.

“The geopolitical situation is extremely volatile and I do think that at some point we’re going to see some kind of event that’s going to cause more havoc than we are anticipating,” he said. “I think we’re really wound up.”

Week In Review

• Morgan Stanley and six other banks sold $4.74 billion of X Holdings Corp. debt, allowing the lenders to finally rid themselves of the bulk of their exposure to the financing they arranged for Elon Musk’s 2022 purchase of the social-media platform.
• Loans to X Holdings Corp. that banks had on their books at big discounts just a few months ago are being sold at face value now, underscoring a growing concern for investors: Demand for leveraged loans is so strong that prices are soaring.
• JPMorgan Chase & Co. is talking to investors to refinance slot machine operator United Gaming LLC’s private credit debt.
• Banks including Citigroup, Goldman Sachs, and Morgan Stanley extended an upfront commitment to Clayton Dubilier & Rice last year to finance its purchase of part of Sanofi’s consumer arm, Opella. They’re waiting to sell the debt to investors until late March or April, after Opella releases its fourth-quarter results, and face the risk of market changes and macroeconomic surprises affecting their profits.
• JPMorgan Chase & Co. is among a trio of lenders preparing to sell a €1.05 billion ($1.1 billion) loan for Colosseum Dental Group, the latest company to refinance out of private credit and into the more liquid syndicated debt market.
• Citigroup Inc. privately placed a portion of the financing that is supporting Lakeview Farms’ acquisition of Noosa Yoghurt, after struggling to drum up sufficient demand for the debt among a wider group of leveraged loan investors.
• Snap Inc. plans to offer $700 million of junk bonds to repurchase convertible debt, the social-media company said in a statement on Monday.
• Rogers Communications Inc. raised $2.8 billion in the US and Canada by selling subordinated notes that mature in 30 years.
• Julius Baer Group Ltd. is getting ready to sell its first Additional Tier 1 bond with an equity conversion clause, joining the Swiss market’s switch away from a structure that drew investors’ ire when $17 billion of Credit Suisse debt went to zero.

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On the Move

• Apollo Global Management Inc. managing director Jamie Caruso is leaving the firm to start his own origination platform. Caruso, who’s based in New York, is set to depart at the end of February. He was involved in the firm’s credit and hybrid value transactions for companies including MRO Holdings Inc. and Capital Vacations.
• Brookfield Asset Management Ltd. has hired Rachel Russell from Morgan Stanley, where she helped lead the bank’s collateralized loan obligation business.
• Deutsche Bank AG has hired Jackson Merchant, the head of leveraged loan capital markets at Mizuho Financial Group Inc.’s US arm. New York-based Merchant is set to report to Ryan Corning, Deutsche Bank’s head of leveraged capital markets in the Americas.
• Morgan Stanley promoted three sales executives under global fixed-income co-heads Jay Hallik and Jakob Horder. Salvatore Orlacchio, head of fixed income in Europe, the Middle East and Africa, will also oversee client coverage globally for the division, while Lindsey Coleman was named head of client coverage for the Americas, and Joseph Anderson was appointed global head of fixed-income cross-platform sales.
• BlackRock Inc. named Michel Aubenas as head of emerging markets fixed income, replacing Amer Bisat, who’s leaving the world’s largest asset manager to become Lebanon’s economy minister.
• Goldman Sachs Group Inc.’s Deyue Hu, who is in charge of the US bank’s China credit flow trading, is leaving to join another company.
• Jefferies Financial Group Inc. has hired Morgan Stanley’s Vivian Li as its Hong Kong-based head of distressed Asia and head of Asia analytics.
• Goldman Sachs Group Inc. has recruited BNP Paribas SA trader Jeff Leung to focus on China credit trading.

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