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Higher-for-longer rates will trigger domino effect on defaults - Janus Henderson

FILE PHOTO: Flags in front of the European Central Bank building in Frankfurt, Germany

By Chiara Elisei

LONDON (Reuters) - The steepest jump in interest rates in decades will spark a domino effect on corporate defaults in the years ahead, asset manager Janus Henderson Investors said in a report on Friday.

Rising borrowing costs are back in stark focus following a rout in government bonds since September as investors adjust to the prospect of interest rates staying persistently high, which has also raised corporate bond yields.

The yield on high-yield corporate bonds peaked on Oct. 20 at 9.3%, versus lows of 7.6% in early February.

The cost of insuring exposure to European junk debt also hit on Oct. 20 its highest level since late March at 473 basis points (bps), according to S&P Global Market Intelligence.

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As firms will have to refinance debt at a higher cost of funding, this will hurt their ability to pay interest, eventually leading to more defaults, the report said.

Defaults have already been rising this year, with the number globally up to September reaching 118, nearly double the 2022 total and well above the year-to-date five-year average of 101, according to S&P.

"The credit cycle tends to turn only if three conditions are present: high debt loads, lack of access to capital, and an exogenous shock to cash flow. These conditions ... are all present today," Janus' global head of fixed income Jim Cielinski said.

"Each cycle is different, but a combination of high debt levels and a higher for longer interest rate environment is putting pressure on companies to service that debt while cutting off access to capital at a reasonable price.”

Small and medium enterprises, which tend to rely on banks for financing, will struggle to secure capital, suggesting defaults will be more pronounced in this market segment.

Credit indicators the asset manager tracks - such as debt loads, access to capital markets, cash flow and earnings - continued to flash red in the third quarter of 2023, the fifth quarter in a row, Janus Henderson, which manages $322 billion in assets, said in its latest global credit risk monitor.

A lagged impact from interest rate hikes compounded by the absence of sizeable debt maturities in the next 12 to 18 months provides some respite in the short term, it said.

Additionally, some firms have benefited from higher inflation lifting revenues and from consumer resilience.

But as inflation starts slowing and higher rates are here to stay, headwinds are mounting, and the risk is that the increase in borrowing costs could outpace revenue growth, it added.

(Reporting by Chiara Elisei; Editing by Yoruk Bahceli and Mark Potter)