Concerns over stagflationary shocks stemming from Middle East conflicts are mounting, leading global investors to significantly increase their aversion to high-risk corporate borrowers, particularly weaker companies that accumulated substantial cheap debt during the era of ultra-low interest rates.

Data indicates that global investors are currently demanding an additional yield of approximately 6.4 percentage points to hold CCC-rated high-risk bonds, marking the largest premium in 14 months.

Concurrently, credit funds are bracing for potentially greater stress in high-risk loans and the private credit sector, which involves leveraged buyout debts amounting to $2 trillion.

The conflict involving Iran has persisted for over three months, with rising oil prices further intensifying pressure on highly indebted borrowers.

A prolonged blockage of the Strait of Hormuz could drive inflation higher, potentially leading to interest rates remaining elevated for an extended period, thereby hampering economic growth.

Lower-rated companies are the first to bear the brunt, as their financing capabilities are far inferior to their higher-rated counterparts.

Mitch Reznick, Head of Fixed Income in London at Federated Hermes, which manages over $900 billion in assets, stated, "If the shift from disinflation to reflation ultimately evolves into stagflation, companies will face a 'toxic combination' of declining operating cash flow and rising cost of capital. This presents an extremely severe challenge for overly leveraged firms."

The divergence within the US leveraged loan market is also pronounced.

Data shows that loans with a composite rating of CC have delivered a negative return of 8% this quarter, while BB-rated loans have recorded a positive return of 1.4%.

Holly Kim, Co-founder of hedge fund Glendon Capital, noted at the Bloomberg Global Credit Forum in New York, "Whether or not we fall into a recession, we are going to go through a default cycle," linking this closely to the debt accumulated during the leveraged buyout bubble of 2021-2022.

A live survey at the forum also revealed that "stagflation" was viewed by participants as the greatest risk to credit markets.

Despite this, some credit investors remain optimistic about companies' ability to cope with higher financing costs.

The spread on US junk bonds recently approached the 20-year low touched in January.

The global average yield for such bonds is around 7%, and they have relatively short durations, making them less sensitive to movements in government debt rates.

Notably, market fragmentation continues to deepen.

Goldman Sachs data shows that the option-adjusted spread in the US dollar market is nearing its highest level since the global financial crisis.

Strategists, including Amanda Lynam, point out that the resilience of BB-rated debt partly reflects a "flight to quality," attributing this to geopolitical and macroeconomic uncertainty.

Globally, the spread between CCC and BB-rated credit is currently about five times, the highest level in over a decade.

Year-to-date, the spread compensation for BB-rated global corporate bonds has narrowed, while the yield premium for CCC-rated bonds has widened by 86 basis points.

B-rated debt is also underperforming the broader market.

David Forgash, Head of Leveraged Finance at Pacific Investment Management Company (PIMCO), stated, "The high-yield market is highly bifurcated." He warned that the speculative-grade market "feels a bit complacent," as debt requiring higher spreads is "hiding beneath the surface of tighter-spread product."

PIMCO also noted that a decade-long boom has fostered sloppy underwriting in the private credit space, with direct lending facing pressure due to concentration in software companies impacted by artificial intelligence.

UBS Group strategists previously warned that if AI triggers severe disruptive changes among corporate borrowers, default rates in the $1.8 trillion private credit market could surge to 15%.

Federated Hermes' Reznick added that consumer-facing companies are under intense scrutiny, and the market may not yet be fully pricing in their risks.

He favors selecting higher-quality credit assets: "It's time to step slightly away from those highly leveraged companies that are risky to the consumer. The default risk taken to chase returns currently is not sufficiently compensated for the irreparable loss if one gets it wrong."

He further noted that if the Strait of Hormuz remains closed, Europe could be more vulnerable to stagflationary shocks than the US.

Raphael Thuin, Head of Capital Markets Strategy at Tikehau Capital in Paris, stated that in Europe, sectors such as chemicals, packaging, auto components, and real estate have generally been under pressure this year.

"Sectors affected by tariffs, energy prices, or Chinese competition often see significant discounts," he said.