Credit Markets’ Calm Veneer Will Crack

Still waters. Debt investors have been surprisingly relaxed in recent years, despite a rapid runup in interest rates. In 2025, the period of tranquillity will end. Firms are grappling with heavy borrowings and expensive funding costs. And losses on risky private-credit loans will mount.

Western central banks jacked up rates in recent years, but corporate bankruptcies stayed low. The trailing 12-month default rate was just 4.6% worldwide in October, says Moody’s Ratings. Now, with central banks easing and companies rushing to refinance at lower levels, the number of failures may fall even further: the same rating agency expects a default rate of below 3% by October 2025.

Yet there are still plenty of overstretched balance sheets, like those of Patrick Drahi’s Altice France or Britain’s Thames Water. S&P Global Ratings counts a total of $489 billion of debt rated CCC or lower, the lowest level at which companies can usually access funds, as of October.

One risk is that central banks keep rates relatively high, perhaps because of resurgent inflation, causing further pain for leveraged firms. S&P estimates that U.S. and European maturities of so-called speculative-grade debt, which has a rating below BBB-minus, will more than double between 2025 and 2026 to $449 billion, and keep rising after that. Firms will have to start refinancing in 2025, which will be tougher and more expensive if rates stay high.

Losses may build up in opaque corners. One reason so few companies have defaulted is that many of them borrowed in private-debt markets, where large fund managers like Ares Management or Blackstone can offer more flexible terms. Yet there are signs of underlying stress. MSCI reckoned in September that non-performing private-credit loans have nearly tripled since mid-2022. The average ratio of EBITDA to interest costs for private companies had halved to just over 1.7 times by September 2024, from more than 3 times in 2021, according to investment bank Houlihan Lokey. That leaves little cushion if earnings fall.

Rising pain may come as a shock to some investors, who have been accepting low returns on risky debt, expecting both yields and defaults to fall. The average premium over benchmark rates, or spread, on high-yield bonds dropped comfortably below 3 percentage points after Donald Trump won the U.S. election. That was the lowest level since before the failure of Lehman Brothers, according to ICE BofA indexes. Assuming bondholders could recover 40% of face value after bankruptcy, it would take a default rate of just over 5% to eat up all that spread. That’s not much more than the historic average of 4.2%. In other words, it’s easy to see how 2025 could be a year to forget.