(Bloomberg) -- Corporate debt, particularly U.S. junk bonds and leveraged loans, is likely to serve as an early warning system for credit stress from the Federal Reserve’s shift to a tighter monetary policy.

The corporate markets are “a canary in the coal mine” for problems that may arise due to interest-rate hikes and balance-sheet contraction by the central bank, say research analysts led by Matthew Mish at UBS Group AG in a Jan. 12 report. Fed officials have made it clear they’re preparing to increase rates as early as March to combat the fastest inflation in four decades.

Overall the ratio of U.S. private sector debt to gross domestic product (GDP) is up only slightly to near 147% from when the Fed last started raising rates in 2015. However, this time corporations have a severely worse risk profile compared to the household sector, and there’s greater potential for the central bank to reduce its balance sheet, said the UBS analysts.  

Investors looking for signs of credit stress should focus on liquidity in the high-yield bond and leveraged loan markets, the strategists said. They recommended watching the lowest-rated junk bonds and loans for weakness, as well as tracking debt and equity performance for B rated technology companies in the leveraged loan market since they generate less cash flow and have greater rate sensitivity. 

To be sure, corporate debt markets should be able to handle the first set of rate hikes, given the recent trend of solid corporate earnings growth, according to the report. And the federal funds rate could increase to near 1.5% from the current range of zero to 0.25% range before there’s any material impact on credit health, said UBS. 

But anything higher, as well as the possibility of global balance-sheet tightening, could expose vulnerabilities, according to the report. 

Non-financial U.S. corporate debt totals $12.5 trillion, or 55% of GDP. Of that, 41% is floating-rate, with yields that will move higher with rising interest rates.

Issuance of B/CCC-rated high-yield and leveraged-loan debt has increased in the last 12 months, and credit spreads that would cushion the impact of higher rates are at historic lows. In contrast, the U.S. consumer has the best debt profile in more than 20 years, the report said. 



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