High-yield debt markets were already in trouble before oil markets collapsed Sunday, and now comes the risk of rising credit defaults and downgrades that could increase borrowing costs for businesses across the board.
"Already starved of liquidity following the sell-off over the last two weeks, a near 20% plunge for oil overnight is likely to result in carnage in the market today," analysts at Deutsche Bank wrote Monday. "The big question though is contagion to the broader [high-yield bond] market outside of energy. In our view it is inevitable."
An exchange-traded fund that tracks the price and yield performance of the U.S. high-yield corporate bond market was trading lower Monday, but it wasn't hit as hard as the stock market, where steep declines triggered circuit breakers that paused trading.
The iShares iBoxx High Yield Corporate Bond ETF was down less than 4%.
Another indicator, the Markit CDX North American Investment Grade Index, jumped to its highest level since February 2016, Bloomberg reported. The credit derivatives index quantifies the perceived risk in corporate credit markets.
Corporate America's debt load has swelled to about $10 trillion in an epoch of low interest rates. Many companies borrowed heavily not only to expand in a growth cycle, but also to boost their stock prices through dividend increases and stock buybacks.
"The fall in oil prices exacerbates the stresses in US credit," Morgan Stanley analysts wrote Monday morning. "Unlike 2016, the risks are not limited to the high yield market alone."
Credit downgrades and defaults result in higher borrowing costs for businesses and eat into corporate profits. They can also cause ripple effects that can amplify a downturn.
Regulators, international organizations and analysts were sounding alarms about the growing pile of corporate debt before the coronavirus outbreak unfolded.
In January, the New York Federal Reserve noted that only two U.S. companies have AAA debt ratings from Moody's or Standard & Poor's, Microsoft and Johnson & Johnson. "The large volume of issuance with a BAA credit rating may pose a financial stability concern," the Fed said.
In February, the 36-member Organization for Economic Cooperation and Development also pointed out the lower overall credit quality of the global bond market. It said the situation leaves the global economy more vulnerable to the negative effects of a downturn.
In December, UBS strategist Francois Trahan said slowing economic activity in 2020 could lead to credit downgrades for companies such as Amazon, 3M and Walmart. "This risk could possibly last throughout all of 2020," Trahan said.
The energy sector has already endured a slew of defaults and credit downgrades after a downturn in oil prices in 2016. But today, there's a greater risk of these defaults spreading to other sectors, analysts say.
"The impact of a sharp decline in oil prices goes beyond the leveraged finance market for US credit," Morgan Stanley analysts said. "While downgrades were contained to energy in 2016, broader weakness in corporate earnings could mean more widespread downgrades this time around.