Deterioration in riskier company balance sheets comes after a surge in borrowing by groups in recent years
Deterioration in riskier company balance sheets comes after a surge in borrowing by groups in recent years © Bloomberg

Companies with speculative-grade credit ratings are spending a growing portion of their profits on interest payments as debt costs rise, causing concern as investors and economists debate the durability of the US expansion.

The deterioration in riskier company balance sheets comes after a surge in borrowing by groups in recent years, boosting their reliance on floating rate debt as they have taken advantage of low funding costs and a hefty appetite for their obligations by lenders. But as the Federal Reserve has tightened policy, the market has reached a tipping point, raising concern that further increases in interest rates could spark trouble for the market.

Analysts at UBS estimate that there are nearly $3tn of loans outstanding from junk-rated groups. Most corporate loans are pegged to a floating interest rate such as Libor. Three-month Libor has climbed more than 60 basis points this year to 2.3 per cent, lifting floating rate loans higher alongside it.

Max Gokhman, the head of asset allocation for Pacific Life Fund Advisors, said that floating rate loans “work great until companies can no longer bear that coupon. When that happens there tends to be a fairly violent unwind. It is exactly what we [saw] in 2008.”

So-called coverage ratios, which measure the profits available to pay off financial obligations, rebounded through 2017 thanks to strong earnings. But as rising interest rates have taken hold in 2018, coverage ratios have declined and expectations that earnings growth will slow in 2019 could result in further deterioration.

For companies rated single-B, a label the big corporate credit rating agencies such as S&P Global and Moody’s assign to groups considered highly speculative, the ratio has fallen to 3.1 times interest in the first quarter. That’s down from 3.9 times six months earlier. For companies with a slightly better rating — those rated single-B plus — the metric has dropped to 3.5 times from 3.8 times, over the same period.

Coverage ratios on all new loans tracked by S&P Global Market Intelligence’s LCD this year have fallen to the lowest levels since 2008 but have yet to collapse to the troughs seen during the dotcom boom and bust and financial crisis.

“It’s a material problem into next year if you have interest costs continuing to rise, the Fed still with its pedal to the metal and earnings slowing down,” said Matthew Mish, a strategist with UBS.

The strong growth and demand for floating rate assets has also given companies more leeway when they negotiate the clauses in their loans with lenders. The trend has been exemplified by a proliferation of so-called add-backs to earnings, where companies add certain costs back to their profits. The move can inflate the amount of cash they appear to have available to repay debt.

Rating agencies say they are watching the trend, but with a US economy benefiting from accelerating growth and interest rates still at historically low levels, it is not yet inhibiting companies’ ability to repay debt.

“Most companies we meet with think they will increase earnings and that they can grow into a balance sheet with rising interest expense,” said Christina Padgett, an analyst at rating agency Moody’s.

Some investors also believe that coverage ratios remain at healthy levels and that recent earnings growth coupled with stable leverage meant the asset class remained in strong shape.

“Yes, risk levels are creeping upward in the loan market but the level of increase in risk at this point is not one that causes alarm particularly as it relates to coverage ratios,” said Steven Oh, global head of credit and fixed income at PineBridge Investments.

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