Risks in High-Yield Bond Markets: Credit Deterioration and Liquidity Crunches in a Rising Rate Environment

A line chart illustrating the trajectory of ICE BofA High Yield default rates from 2020 to 2025, juxtaposed with the 10-year U.S. Treasury yield, highlighting the inverse relationship between interest rates and default rates during periods of tightening.

The high-yield bond market, long a cornerstone of risk-adjusted returns for income-seeking investors, faces mounting challenges in the current rising interest rate environment. While default rates have remained historically low-1.4% as of early 2025, well below the decade average of 2.8%, according to the Guggenheim report-the underlying credit quality of the market is showing signs of strain. This tension is most acute in lower-rated corporate debt (CCC/CC), where liquidity risks and sector-specific vulnerabilities threaten to amplify systemic fragilities.

Credit Deterioration: A Mixed Picture

The high-yield bond index has evolved significantly since 2020, with higher-rated BB bonds now comprising a larger share of the index, while CCC-rated bonds have dwindled, as noted in the Guggenheim report. This shift has helped suppress default rates, but it masks growing sectoral imbalances. Commercial real estate (CRE) and energy firms, for instance, face acute refinancing pressures. Many CRE borrowers issued fixed-rate debt during the low-interest-rate era of 2020–2022, now maturing in a high-rate environment. As of 2025, the bottom 20% of high-yield issuers by credit quality have refinanced only 15% of their debt, compared to 30–35% for higher-rated peers, according to a Kavout analysis. This disparity underscores the fragility of leveraged firms in a tightening monetary policy regime.

The UBS 2025 Fixed Income Default Study further highlights sectoral risks. In the U.S., healthcare and telecommunications sectors are flagged as negative outliers, with defaults driven by single-issuer concentration risks. Meanwhile, Chinese real estate firms in Asia ex-Japan dominate the 5.7% default rate for the region, reflecting a broader crisis of overleveraged balance sheets and liquidity mismatches.

Liquidity Crunches: The Hidden Vulnerability

Liquidity in high-yield markets has deteriorated unevenly. While bid-ask spreads for investment-grade bonds have narrowed-falling to 0.08% of par in European markets and 0.8% in the U.S. as of 2025, per SIFMA statistics-CCC/CC-rated bonds remain illiquid. These lower-rated issues, often issued by smaller firms with opaque financials, trade infrequently and face wider spreads. During the 2020 pandemic crisis, liquidity in CCC bonds collapsed as market makers withdrew, forcing investors to rely on slower, less efficient agency trades, as shown in a COVID-19 liquidity study. Though the Federal Reserve's Secondary Market Corporate Credit Facility (SMCCF) temporarily stabilized the market, such interventions are not a permanent solution.

The 2024–2025 period has seen renewed liquidity strains. For example, the effective yield on U.S. High Yield CCC bonds stood at 12.49% in July 2025, below its long-term average of 14.12%, according to YCharts data, suggesting compressed risk premiums despite deteriorating fundamentals. This compression is concerning given the "maturity wall" of high-yield debt, with 10% of the market maturing before 2026, as YCharts shows. Firms with floating-rate debt, particularly in energy and retail, now face higher interest coverage ratios and refinancing costs, exacerbating liquidity stress, a point also highlighted by Kavout.

Policy Uncertainty and Systemic Risks

The interplay of rising rates and policy uncertainty further complicates the outlook. The U.S. corporate default risk rate hit 9.2% in 2025, a post-financial crisis high, driven by macroeconomic headwinds such as inflation and geopolitical tensions, according to Moody's analysis. While high-yield default rates remain below this level, the risk of a wave of defaults in a stressed scenario-such as a sharp rise in tariffs or a prolonged recession-could strain bank capital, particularly in emerging markets. Nonbank financial institutions, now accounting for 40% of global syndicated loans, add another layer of complexity, as their role in credit intermediation could amplify contagion risks, as noted in the Guggenheim report.

Conclusion: Navigating the Risks

Investors in high-yield markets must balance the allure of elevated yields with the realities of credit and liquidity risk. The current environment favors higher-quality BB-rated bonds, which offer tighter spreads and stronger covenant protections, a conclusion consistent with the UBS study. However, the allure of CCC/CC bonds-despite their volatility-remains strong for those seeking yield, provided they employ rigorous due diligence and liquidity management.

As the Federal Reserve navigates the "higher for longer" rate environment, the high-yield market's resilience will depend on corporate balance sheets, sectoral diversification, and the availability of liquidity backstops. For now, the market appears to be holding up, but the risks of a liquidity crunch or credit downgrade wave remain a looming shadow.

A bar chart comparing bid-ask spreads for investment-grade, high-yield (BB-rated), and CCC/CC-rated corporate bonds from 2020 to 2025, with annotations highlighting key events such as the 2020 pandemic crisis and the 2023 banking sector turmoil.