Three risk factors in high-yield credit that the market ignores

Mauro Ratto, Co-Founder and Co-Chief Investment Officer at Plenisfer Investments SGR

The current cycle is characterized by its exceptional length, with spreads at historic lows and very low default rates. In this environment, the High Yield credit segment appears particularly solid.

But is it really so?

An analysis of ongoing dynamics reveals three risk factors that the market tends to underestimate.

The first is the correlation between lower default frequency and the increasing prevalence of unconventional corporate liability management transactions.

Among these are uptiering operations, increasingly common in the United States and now also in Europe. Through these operations, a financially stressed company signs a new financing agreement with one or more “last-resort lenders”—generally private debt funds—who, taking advantage of limited or virtually non-existent contractual protections on existing debt (bonds and often also bank loans), provide new secured debt that ranks at the top of the capital structure, i.e., with repayment priority over existing creditors. In the short term, this allows the company to avoid default and enables the controlling shareholders to maintain control of the firm, to the detriment of existing creditors—bondholders and often banks—whose claims become subordinated and thus effectively devalued even in the absence of an immediate default.

The growing relevance of such operations must also be assessed considering the increasing size of Private Debt, currently estimated at about $2 trillion^[1], as the vast availability of capital to deploy in the market exponentially raises the risk of deterioration in credit quality and lending standards. The recent bankruptcy of auto parts manufacturer First Brands exemplifies how, in today’s market context, a company with questionable governance, financing, and collateral could pursue aggressive debt policies and, in the face of a liquidity crisis, postpone its failure for an extended period through opaque financial manoeuvres, including off-balance sheet items amounting to several billion dollars.

The collapse of First Brands thus highlights the significant risks associated with the lack of transparency in off-balance sheet transactions and complex commercial financing arrangements, which can generate substantial losses and reputational damage for major financial institutions. Moreover, the collapse of First Brands may well represent a canary in the coal mine—the first evidence of a severely underestimated risk that could spread across the market, given its size and the fragility of the underlying assets.

In this context, only a careful analysis of prospectuses and credit protection covenants, alongside an assessment of management and ownership quality, enables investors to properly quantify the associated risks, which are currently largely underestimated.

On the other hand, as unconventional corporate liability management transactions increase, so do related litigations. In the “Serta Simmons” case, a U.S. Court of Appeals found that a super-priority debt offer to a selected group of creditors violated the principle of pro rata repayment and the implied covenant of good faith. In that specific case, the Court highlighted the limits of liability management transactions that alter creditor priority without the clear agreement of all parties involved. This is the second risk factor: a growing awareness that subordination is not guaranteed could trigger a crisis of confidence in these operations and their vehicles, not unlike the one experienced during the subprime crisis. The contagion effect could quickly spread the crisis to the High Yield bond segment.

In this context, the Ardagh Group case is instructive. The “financial gymnastics” linked to these liability-management operations alters the traditional priority hierarchy, which in a debt restructuring would normally see the equity wiped out. Ardagh Group—a distressed Irish producer of metal and glass packaging—recently restructured its balance sheet through a debt-for-equity swap covering approximately $4.3 billion of debt within a total debt load exceeding $10 billion. In this operation, senior secured creditors are largely protected, while holders of senior unsecured notes receive 92.5 % of the equity in a privately held company and gain control, whereas holders of Payment-in-Kind (PIK) notes are heavily diluted, receiving only 7.5% of the equity. Notably, Ardagh’s existing shareholders are to receive about $300 million, of which just over $100 million will go to the controlling shareholder, in exchange for relinquishing their stake. The transaction has already drawn legal challenges from certain PIK creditors, who argue that it violates the customary order of debt-and-equity priority, but it remains a case illustrating how, in high-yield issuer restructurings, the line between debt and equity can become extremely blurred.

The third risk factor in High Yield credit concerns the growing phenomenon of issuances aimed at distributing dividends to shareholders, the so-called dividend recaps. Historically marginal in total HY issuances, these operations have become more significant in 2025, reaching by early summer 8% of European HY issuances and approximately 5% in the U.S^[2]. Simultaneously, leveraged buyouts and IPOs of private equity-backed companies have contracted: despite an equity market characterized by high multiples, funds struggle to bring companies to market. The consequence for funds is a reduced ability to return capital to their investors, a difficulty mitigated through dividend recap operations. These transactions allow funds to distribute cash while retaining control of companies, albeit at the cost of increasing overall leverage and the risks associated with the sustainability of debt and future cash flows.

This trend requires investors to pay closer attention to the actual quality of the debt and the sustainability of the issuer’s capital structure, going beyond mere ratings or spread levels when analysing investment opportunities.

Conclusion

The vulnerabilities identified remain under close observation. Ultimately, a persistent conflict between different creditor classes harms the credit market itself: the resulting uncertainty translates into higher capital costs and, ultimately, penalizes private market operators, who in turn rely on credit to support their activities. The deterioration of this ecosystem will be largely influenced by the evolution of the macroeconomic cycle: any potential slowdown could act as a catalyst for a more extended phase of financial stress.

Now more than ever, financial leverage, covenant quality, and contractual clauses in credit transactions are of critical importance. The purpose of the debt and, above all, the presence of a high-quality management team—transparent and capable of maintaining capital market trust—are decisive factors in building solid and resilient credit portfolios.

Active, flexible management based on quantitative and qualitative analysis allows investors to avoid excessive exposure to seemingly safe instruments, capture opportunities arising from risk mispricing, and preserve capital in contexts of heightened volatility or macroeconomic stress.

^[1] Source: Mercer, ‘Private Markets in Motion – Private Debt’

^[2] Source: Dechert LLP