A key indicator in Europe’s credit market is signaling that there’s trouble ahead for junk bonds.

The extra cost to protect against default for Europe’s risky corporate bonds compared to investment-grade debt has more than doubled this year, according to IHS Markit indexes of credit-default swaps. The gap between the gauges widened significantly on Friday, after US inflation data surprised the market and fueled bets of more aggressive interest-rate hikes. Similar bets are being made in Europe, and the gap has widened further.

The chasm -- now at the widest since May 2020 -- underscores anxiety among investors as fears of recession in Europe and the US mount. Traders are betting that the Fed will raise rates by 75 basis points at least once in the next three meetings. In Europe, wagers on two 50-basis-point rate hikes by the ECB is causing a slump in bond prices.

“Increased demand for credit hedges from credit portfolio managers and macro investors has contributed to the decompression,” said Kamil Amin, a credit strategist at UBS AG. “There is concern about EU growth, more so now given inflation dynamics,” he said.

With the risk of stagflation mounting, junk-rated corporates face the prospect of falling income and higher borrowing costs simultaneously, which could hamper their ability to repay their debts. Deutsche Bank estimates that default rates in Europe for junk will roughly quadruple to 3.8% by the end of 2023, and soar to 6.6% the following year.

That said, Europe’s long running issue with liquidity has been a saving grace for corporate bonds. Instead of selling bonds frantically, investors are turning to the CDS market to hedge against risks, according to UBS’s Amin.

Still, it’s been a difficult year for credit, with losses across most major markets in the double digits. The European Central Bank’s decision last Thursday to stop adding to its quantitative easing programs from July and raise interest rates thereafter adds to the pain.

“Last week’s hawkish ECB statement is likely to continue to weigh on sentiment in European credit,” UniCredit SpA analysts led by Tullia Bucco wrote in a note on Monday. “Thus, we are likely to see credit investors preferring quality, with high-grade corporates and SSAs outperforming, and high-yield and hybrid credit underperforming.”

This article was provided by Bloomberg News.