Junk Risk Spikes as Recession Odds at Post-Crisis High, UBS Says

  • Record defaults possible amid Fed rate hikes, slow growth
  • ‘Worst case is, you have a replay of 2015,’ a very bad year

The chance of a U.S. recession next year is the highest it’s been since the credit crisis and that could spark record defaults among high-yield companies, according to UBS Group AG.

There’s a 34 percent likelihood of a recession by the first quarter of 2017, according to the UBS credit-based recession probability index, and those chances could jump to 50 percent next year if the U.S. Federal Reserve raises interest rates at a rapid pace. As banks tighten lending standards, the prospect of the Fed raising rates amid weak economic growth could create conditions similar to last year, when junk bond investors suffered their first loss since 2008, UBS strategist Stephen Caprio said Tuesday in a phone interview.

“The biggest risk right now does come from Fed rate hikes amid a period of weak growth data,” Caprio said. “The worst case is, you have a replay of 2015, where you have a tighter Fed, stronger dollar, oil prices take another leg down into the $30s and concerns over emerging markets and China flare up again -- that’s going to lead to mutual-fund redemptions."

He recommends investors looking for exposure to risky assets buy U.S. equities rather than high-yield bonds.

‘Biggest Risk’

Fed Chair Janet Yellen said Monday that additional gradual interest-rate increases are appropriate, without specifying their precise timing. Gold futures rose and the U.S. dollar fell to a three-week low after her less-hawkish-than-expected speech sparked market sentiment that the Fed would delay a rate increase.

The probability of the Fed raising rates at its next meeting, June 14-15, fell to zero from 24 percent a week ago, according to futures data compiled by Bloomberg. Traders see an 18 percent chance of an increase at the next meeting in July.

Even if the Fed refrains from raising rates over the next two months, high-yield debt’s future performance could likely disappoint and spreads could become expensive, according to the strategists. Investors’ search for returns is “over-hyped,” strategists led by Caprio wrote in a note Tuesday, and fund allocation is going to high-grade U.S. credit over junk.

"Bottom-line, high-yield firms need a materially dovish Fed to continue outperforming equities," the strategists wrote.

UBS forecasts default rates will climb to 5.5 percent by mid-2017, from the current 4.4 percent. “You could have default rates that hit a record this cycle in a recession," Caprio said.

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