Financial pain is spreading in the junk-loan market, showing how interest-rate increases are hurting debt-laden companies and worrying investors that a credit crunch looms as the economy slows.

Defaults on so-called leveraged loans hit $6 billion in August, the highest monthly total since October 2020, when pandemic shutdowns hobbled the U.S. economy, according to Fitch Ratings. The figure represents a fraction of the sprawling loan market, which doubled over the past decade to about $1.5 trillion. But more defaults are coming, analysts say.

Interest payments on the loans float in lockstep with benchmark interest rates set by the Federal Reserve. The higher the central bank raises rates, the tighter the squeeze on companies that borrowed when rates were close to zero.

One sign of concern—a flurry of reports published by investment banks after Fed Chairman Jerome Powell signaled on Aug. 26 his intent to keep rates high to suppress inflation. Wall Street firms sounding the alarm included Bank of America Corp., UBS Group AG and Morgan Stanley, which called the loans a “canary in the credit coal mine.”

“Borrowers are particularly vulnerable to the double whammy of weaker earnings and rising interest rates,” Morgan Stanley strategist Srikanth Sankaran said. That will trigger a wave of credit-rating downgrades and push average loan prices—currently 95 cents on the dollar—below 85 cents, a level breached only during the 2008 financial crisis and the depth of the Covid-19 pandemic, he said.

Falling loan ratings and prices will make it harder for companies to borrow to fund growth or to repay their existing debts. Tighter financing also drags on growth, increasing the risk of the US economy falling into a hard landing. New loan sales have already dropped to $334 billion this year, compared with $532 billion in the first eight months of 2021, according to Leveraged Commentary & Data.

The slowdown is already hurting Wall Street banks that committed to loans earlier in the year—often backing takeovers by private-equity firms—and now need to sell the debt to investors. A syndicate of banks is preparing to unload about $16 billion of debt financing they underwrote for the purchase of Citrix Systems Inc.

by Vista Equity Partners and Evergreen Coast Capital, according to data provider LevFin Insights.

Forecasts for the loan market’s benchmark interest rate—the London interbank offered rate, or Libor—shot up in recent months as the Fed raised rates faster than expected to combat persistent inflation. Traders now expect one-month Libor, which is currently around 2.6%, to hit 4.07% by May 2023, up from the 3.15% they had forecast in April, according to data from Chatham Financial. Expectations are similar for the Secured Overnight Financing Rate, or SOFR, which is slated to replace Libor as the loan market’s benchmark rate next year.

Interest costs for an average company with debt consisting of leveraged loans have increased sharply and will likely continue to rise into next year, according to research by Barclays PLC. The percentage of loans in default will likely rise to roughly 3.25% in mid-2023 from about 1% now, but it could go significantly higher, said Jeff Darfus, a credit analyst at the bank.

Data from a recent Fed survey of loan officers at top banks showed tightening lending standards that a Barclays’s model predicted could cause roughly 4.5% of the loans to be in default a year from now, he said.

Federal Reserve Chairman Jerome Powell, at the Kansas City Fed’s annual symposium last month, said the central bank must continue raising rates until it is confident inflation is under control.

That is below the peak default rate of around 7% in 2020. But the pandemic credit crunch was short because the Fed cut interest rates and flooded markets with cash to spur growth. Now the central bank is doing the opposite, and the elevated default rates could last two to three years, analysts say.

Companies at higher risk of default run the gamut from mattress maker Serta Simmons Bedding LLC to software company Avaya Holdings corp. and restaurant-equipment supplier TriMark USA LLC, according to Fitch.

To be sure, most borrowers don’t have to repay their loans for several years, giving them some financial breathing room. Even among the companies at greatest risk, about 75% of their loans mature in three years or more, according to Fitch.