Do you hear that? That’s the sound of credit markets creaking, despite the risk of recession rising by the day as supply chains remain clogged, inflation erodes demand and growth slows.

How should corporates respond to these growing threats?

1/ Don’t bank on things getting less expensive anytime soon

Central banks have made their priorities clear. The Federal Reserve is less than a month away from its anticipated second hike, the first raise of 50bps earlier this month being the highest step up in its base rate since 2000.

The Bank of England has also just raised interest rates for the second time by 25bps to 1.00% and warned of recession and further hikes.

While the European Central Bank (ECB) has resisted hawkish action so far, officials have begun to signal that they are now more open to hiking rates in the coming months, after eurozone inflation hit a wincingly high record 7.5% in April.

According to a Reuters poll of economists, the ECB is expected to raise the deposit rate in July for the first time in over a decade and set it in positive territory in September. And that’s without mentioning the start of the treasury bond sell-off as quantitative tightening comes into view.

Make no mistake, central banks have unbridled inflation in their crosshairs and it’s showing in credit markets.

2/ Yields are yielding to the pressure 

Rising macro risks combined with the tightening environment are putting pressure on secondary high yield bond prices and forcing primary issuers to pay more punitive coupons to get deals away.

The Markit iTraxx Europe Crossover index, which comprises 75 equally weighted credit default swaps on the most liquid junk bond issuers in Europe, was flirting with 500bps on 19 May, versus around 428bps on 29 April. Meanwhile, the ICE BofA Euro High Yield Index Effective Yield breached the 500bps mark for the first time since May 2020.

From a sovereign perspective, Italy looks like it will bear the brunt of rate squeezes. Earlier this month, the yield on Italian 10-year treasuries topped 3%, a more than two percentage point differential with German bunds as Europe’s more indebted countries feel the pain.

3/ Leveraging opportunities are on the horizon

It’s a difficult time for the region’s leveraged finance markets, which went on hiatus in February and March, and a good buying opportunity for funds with a high-risk appetite, provided default rates don’t spike.

There is more than €100 billion in large-cap financing due to hit the market. Among these is the downsized and delayed £6.6 billion loan-and-bond package of UK supermarket chain Morrisons. It’s been a closely watched deal given its size, representing a bellwether for the wider market. Last month, agencies downgraded the company’s credit rating.

If the delays in getting that debt package away persist, investors will surely reprice the risk on its bonds. The question is, how high can yields go before something breaks?