By Anna Hirtenstein 

Worries of an imminent recession have receded lately, especially after last week's robust jobs report, but some European investors are still concerned that next year could see economic shocks and trouble for U.S. high-yield debt.

Economists at Société Générale are among the most bearish out there. They forecast the U.S. economy is poised to contract in the quarters ending in June and September. If such a scenario played out, defaults on speculative-grade, or junk, bonds could rise as much as threefold next year, given all the debt that risky companies have taken out of late.

High-yield debt markets have already been somewhat more jittery than stocks, which remain near record territory. A high level of debt at U.S. companies with subpar credit ratings is likely to magnify problems in the junk-bond market if the economy shrinks, and low borrowing costs have historically failed to prevent a jump in defaults at such times, said the economists at the French bank.

Foreign capital has flowed out of U.S. high-yield bond funds since the beginning of the year, with cumulative outflows reaching roughly $3.5 billion in early December, according to data from Emerging Portfolio Fund Research. That compares with an inflow of about $3 billion into investment-grade bond funds.

"If you look under the hood, there are some weaknesses," said Michael Scott, a fund manager at investment firm Man GLG. He expects default rates to peak at 5% next year, with an increase particularly among oil-and-gas companies. "We'll see companies struggle to refinance debt, " he said.

Output may shrink by an annualized 0.9% in the second quarter and by 0.8% in the third quarter, marking the worst performance for the U.S. economy since the 2009 crisis, according to the economists at Société Générale. The scope for further monetary policy easing is limited, while the fiscal deficit of 4.6% as well as the impeachment proceedings against President Trump may curtail fiscal spending until after the November elections, they said.

A recession would prompt a jump in defaults within speculative-grade, or junk, bonds to as high as 10.2% by September, from the current 2.9%, according to the French bank's strategists.

"The U.S. economy is being held up by consumers. Corporates aren't adding to the economy at the moment," said Juan Valencia, a credit strategist at Société Générale. "Leverage is on the rise. At the moment, it's OK, but if we have this slowdown then spreads will react and defaults will pick up."

Investors this year have already been demanding more compensation to hold the lowest-rated tier of U.S. corporate bonds than at any time in more than three years, highlighting a selloff that some have taken as a warning signal for other riskier assets. A widening in bonds spreads -- or the extra yield that investors demand to hold the debt over U.S. Treasuries -- are typically a sign of a rising threat of default.

The U.S. high-yield market has already been very volatile, with some defaults in the energy sector, said Andrey Kuznetsov, a senior credit portfolio manager at Hermes Investment Management. Investors are watching for any signs of a recovery in 2020, and some companies are expected to propose restructuring their debt, he said.

The ratio of net debt to earnings before interest, tax, depreciation and amortization are close to record highs for U.S. high-yield companies, Société Générale's report showed.

While the global economy is expected to continue to deteriorate next year, European high-yield debt markets may not see the same jump in defaults as companies in the region are less leveraged, Société Générale said.

--Lorena Ruibal contributed to this article.

Write to Anna Hirtenstein at anna.hirtenstein@wsj.com

(END) Dow Jones Newswires

December 09, 2019 09:17 ET (14:17 GMT)

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