Franklin Templeton expects more debt defaults from junk firms

More junk-rated companies are likely to default on their debt as the U.S. economy slows, according to Franklin Templeton, which is waiting for wider spreads before buying the bonds.  

The $1.4 trillion asset manager, which is currently underweight U.S. high yield, may add exposure if spreads start to price in distress and widen to 600 to 700 basis points over Treasuries, according to portfolio manager Benjamin Cryer. That compares to a spread of 393 basis points on Wednesday.

“We don’t see growth falling off a table, which does create opportunities for below investment-grade sectors,” Cryer said in a interview Tuesday. “To the extent that the market gets more pessimistic, that’s when we would look to get more in an overweight position.” 

A debt market correction may occur as the labor market and growth deteriorate, boosting defaults from risky companies which haven’t yet felt the impact of higher rates, according to Cryer. Any recession would likely be relatively shallow and would therefore be unlikely to cause a big spike in missed payments, he added. 

Fears of a U.S. slowdown haven’t deterred yield-hungry investors. Junk bonds have held up well, delivering a 5.6% gain this year, even as Treasuries and U.S. investment-grade notes sank into losses.  

If the U.S. avoids recession altogether next year, there will be opportunities to buy more cyclical names and lower-quality bonds, Cryer said. He co-manages the Franklin Strategic Income Fund which has returned 2.5% this year, outperforming 81% of its peers. 

“There certainly is risk in the high-yield market. But you know, I think we view it generally as good risk,” Cryer said.

Fitch Ratings Inc. said in May it expected defaults to rise for the remainder of the year on constrained liquidity and tighter lending conditions. A looming wall of about $1 trillion in junk debt maturities over the next three years leaves riskier corporates no option but to refinance.