Rising Short-Term Interest Rates Pressure Leveraged Firms with High Borrowing Costs

The sharp increase in short-term interest rates, spurred by persistent inflation and steady economic growth since 2022, has resulted in the highest borrowing costs seen in decades across developed markets. This scenario has placed substantial strain on highly leveraged companies that depend on variable-rate debt. Over the last twenty years, a growing number of corporations have opted for floating-rate loans instead of bonds, which would have provided more stability in their borrowing costs over time.

This shift aligns with the uptick in private equity-owned firms that regularly access the broadly syndicated loan market, collateralized loan obligation (CLO) funds, or private lenders such as major investment firms. The CLO market has nearly quadrupled since the global financial crisis, approaching a value of nearly $1 trillion, according to financial analysts. Projections suggest that by 2027, the global private debt market could double to $2.3 trillion.

The move towards loans occurred during a low-interest-rate environment, a situation that has now changed, creating challenges for borrowers, particularly those with debt ratings classified as single B or lower. However, more relaxed creditor protections introduced over the last decade have afforded these companies some leeway to navigate short-term economic challenges.

Eased covenant requirements have allowed many borrowers to forgo hedging strategies against rising rates on their floating-rate debts, a choice that may now be regrettable. Analysts warn that by the end of this year, more than half of U.S. companies rated single B-minus will struggle to generate enough cash flow to cover their capital expenditures and debt servicing.

The uptick in interest costs has primarily affected sponsor-backed firms, severely impacting lower-quality borrowers. Predictions point to a potential decline in interest coverage ratios for these companies, dropping to 0.91 by December, down from 1.32 at the close of 2022. This suggests that these companies may struggle to meet their interest obligations.

Forecasts indicate that U.S. corporate default rates could rise to 4.5% by June 2024, a notable increase from 1.7% at the beginning of 2023. Despite these challenges, ongoing economic growth and the capacity to manage rising debt loads have provided some relief for leveraged companies.