If interest rates rise, do we have to worry about credit defaults?

Thanks to rising inflation, central banks on both sides of the Atlantic are pondering whether they have to hike interest rates. But higher interest rates have knock-on effects throughout credit markets, and in a world where we worry about excessive private credit exposure, should investors be worried about rising default rates due to rising policy rates?

The people at the Bank for International Settlements (BIS), famously called the ‘central bank of central banks’, are clearly concerned about this possibility. They investigated how rising central bank policy rates lead to rising default rates in loan markets. But crucially, they provide some useful rules of thumb for investors depending on the prevailing macro and interest rate environment before rate hikes began.

The headline result is that a one percentage point increase in central bank rates on average leads to a 0.1 percentage point increase in default rates for private market loans. That sounds like nothing, and I admit it isn’t large, but note that the current default rate for private market loans in the US is 1.3% and in Europe 1.4%.

However, the study also tests for different macro environments before the rate hikes begin, and they can increase the effect significantly.

Effect of interest rate hikes on loss rates in adverse economic conditions

Source: Fandl et al. (2026)

The figures above need some explanation. The blue line in each figure shows the change in loan default rates in reaction to a one percentage point increase in policy rates if none of the adverse conditions stated in the headline of the figure is present. The light blue area around these lines gives the 90% confidence interval. This is the reference benchmark against which the black and pink lines need to be assessed, and they show that rate hikes can easily be digested if the economy is doing great before the rate hikes begin.

The dashed black line shows the change in default rates if the stated adverse conditions are in place before the rate hikes begin, but monetary policy is loose. The pink line shows the change in default rates if the adverse conditions are in place and the monetary policy is tight beforehand.

Looking at the four figures, I would argue that we are currently entering a phase of potential rate hikes with an economy that has high debt levels and lots of loans outstanding that have floating rates, rather than fixed rates. Hence, the bottom right figure seems most appropriate for the current situation. In the US, we have the additional complication of high inflation rates, while in Europe, we face the challenge of an economic slowdown (but not too high inflation). Each of these additional adverse factors is likely to increase the default rate even more.

But even so, the figure shows that a one percentage point increase in policy rates (something that is currently priced in money markets for the Eurozone, but not the US) is likely to trigger a 0.3 percentage point increase in default rates in the first year. And given current default rates, that is the same as saying that default rates in private loan markets may rise by a third.