Increased borrowing costs are hindering companies’ ability to service outstanding debt from earnings, creating a risk for rating downgrades and defaults as they lose access to debt capital markets.
After a decade of ultra-low interest rates, borrowing costs have shot up in the aftermath of the coronavirus pandemic as central banks embarked on a series of interest rate rises to bring down inflation from multi-year highs. While price pressures have moderated in the last months, inflation remains above central banks’ targets, indicating they may continue to lift base rates as the economy slows, hurting company earnings prospects.
“It's a new world we're entering, right now everybody's looking more at interest cover ratio than leverage ratios because a lot of these companies are struggling to service their debt at that level of costs,” said one senior leveraged finance banker.
Companies have started taking action, focusing primarily on cutting down their debt loads.
Israeli generic drugmaker Teva Pharmaceutical Industries's management said it intends its reduce its net debt-to-ebitda ratio to 2x by end-2027, as its recent debt refinancing leads to a higher interest expense, Lucror Analytics wrote in a recent note. UK sportscar maker Aston Martin Lagonda is taking a different approach, using proceeds from a rights issue to redeem the US$236.1m outstanding of 15% second-lien notes due 2026. It's targeting a debt reduction to 1.5x in 2024–25 from 4x at the end of the first half of this year, Lucror noted.
Riskier companies are more vulnerable. Coverage ratios are typically thinner for those carrying lower ratings due to their higher leveraged and risk premiums, according to research from Commerzbank showing that coverage ratios hover around the low-to-mid single digits on average for Single B rated firms, increasing to low-to-mid teens for investment-grade companies.
Time bomb
High-yield companies face shorter maturities, which makes them more reliant on debt capital markets to push out repayment deadlines and stay afloat. Also, they typically have a higher share of floating-rate debt, making them more vulnerable to surging interest rates.
"Higher interest rates eat into their fundamentals at a much faster pace”, creating a "coupon time bomb", credit strategists at the German bank wrote in a note. “Many issuers should struggle to prevent a meaningful deterioration in their interest cover ratios, creating a risk for ratings and extending the window of structurally higher default rates."
There were some €153bn of European junk-rated debt, including bonds, loans and revolving credit facilities, maturing in 2023 and 2024 as of January, according to S&P data.
Activity in the new issue high-yield market has been dominated by refinancings this year, with coupons more than doubling depending on the issuer and rating compared with those on the debt being replaced, illustrating a substantially higher interest burden for the better-rated high-yield firms.
For instance, last month Double-B rated Energia issued a €600m 6.875% five-year non-call two bond to refinance the company's £225m 4.75% September 2024 and €350m 4% September 2025 bonds. Also in July, Single B rated Telecom Italia printed a €750m 7.875% five-year senior unsecured note to take out 3.625% notes due January 2024 and 4% bonds due April 2024 via a tender offer.
The average yields of new issue euro bonds rated Double B and Single B is well above the average level between 2016 and 2021 and will increase further going into 2024, pointing to “painful refinancings ahead," Commerzbank's credit strategy team said.
The yield on the ICE BofA Euro High Yield Index was quoted at 7.21% on Monday morning, up from 2.37% two years ago, according to Refintitiv data.
Despite demanding a bumper compensation to offset a higher probability of default, investors remain risk-averse. Altaf Kassam, head of investment strategy and research for EMEA at State Street, said he is cautious on high-yield debt due to heightened refinancing and default risk, in contrast with a more favourable view on fixed income, which he said should fare well as inflation weakens.
A weaker growth outlook coupled with borrowing costs is now widely expected to drive up defaults in the coming quarters.
Fitch forecasts the trailing 12-month European high-yield bond default rate is set to jump to 2.5% from 1.6% by the end of 2023, climbing to 4% by the end of 2024 due to a higher number of issuers with unsecured instruments in cyclical sectors.
Meanwhile, Moody’s expects global high-yield corporate defaults to peak at 5% by the end of April 2024, from 3.4% in May.