Since early 2022, the fed funds rate has increased at its fastest pace since the 1980s, leading investors to rapidly adjust to a world of higher market interest rates, steeper inflation, and more interest rate volatility.

An environment of higher rates could have unintended consequences, including more future volatility in what currently appears to be a still-healthy high-yield bond market. Over time, this could lead to an increase in the number of companies that fall into distress, given the significantly higher cost of capital.

This could negatively affect leveraged firms—especially capital-intensive companies with low interest rate debt that comes due in the coming years. The rising cost of capital could be a prolonged problem for borrowers—potentially for the next five years or longer (see “The rising cost of capital and its investment implications,” written by the Fidelity Asset Allocation Research team).

In time, these market dynamics could lead to more yield spread dispersion in the high-yield bond market, which has already happened to a degree. Yield spread dispersion (we’ll refer to it as dispersion going forward) is calculated at the end of each month as the percentage of the par value of bonds in the BofA U.S. High Yield Bond Index trading at least 100 basis points (bps) in either direction from the index spread. Dispersion has risen over roughly the last two years, coinciding with higher interest rates and reduced pandemic spending by the federal government.