Companies have demonstrated unexpected resilience in the face of a considerable hike in official interest rates. Can this continue in an economy that is expected to slow due to the 'high policy rates for longer' environment? The Federal Reserve's new Financial Stability Report provides some comfort by comparing corporate bond rates and spreads to their historical distribution. Furthermore, resilient earnings indicate a strong debt-servicing capacity. Is this assessment applicable in a stress test scenario? A recent Federal Reserve analysis suggests that the debt-servicing capability of the US public corporation sector as a whole is resilient to sustained high interest rates, unless there is a severe economic downturn. Unsurprisingly, companies with already poor balance sheets are significantly more vulnerable to continuously increasing interest rates or a sharp reduction in growth. Such a development could have an impact on the larger economy via client-supplier relationships, the labor market, and, potentially, a contagion effect in corporate bond markets.
As discussed in the previous issue companies have been very resilient in the face of a significant increase in official interest rates due to several financial factors
profitability, cash levels accumulated during the Covid-19 pandemic, the ease of capital markets-based funding, and low long-term rates locked in during the pandemic. Intangible assets are also playing an increasingly important role since they are less responsive to interest rates, decreasing monetary transmission. Can this resiliency endure in an economy that is expected to slow due to the 'high policy rates for longer' environment? The Federal Reserve's Financial Stability Report[2], released in April, provides some comfort. Yields on both investment and speculative grade bonds are at the middle of their respective historical distributions. Corporate bond spreads have reduced to modest levels compared to their historical distributions. The excess bond premium, which measures the difference between corporate bond spreads and predicted credit losses, is close to its historical average. Furthermore, interest coverage ratios (ICRs) — earnings before interest and tax divided by interest payments — indicate "robust debt-servicing capacity, reflecting resilient earnings." Nonetheless, constant monitoring will be required in the future, given that the economy is slowing (as evidenced by the fall in the hiring rate and the rise of nonfarm payrolls), and the FOMC argues that it is not in a hurry to cut rates due to inflation's stickiness. Furthermore, according to the Federal Reserve, "expectations of year-ahead defaults remained somewhat elevated relative to their history," and the vulnerabilities of unlisted small and middle-market enterprises are increasing.
Furthermore, the delayed effect of previous federal funds rate rises remains a source of concern
According to a Federal Reserve Bank of Boston analysis last yea, the pass-through of higher official rates into firms' interest expenses has historically occurred with a five-quarter delay because the share of corporate debt that is floating-rate debt is relatively small, so the pass-through is dependent on fixed-rate debt that matures and needs to be refinanced. This delay implies that interest rates are bound to rise, given that the FOMC raised its policy rate until its July meeting last year. In this instance, high interest rates may continue to have a considerable negative influence on investment and hiring decisions in the coming quarters. Access to finance may also become more challenging since "many debt contracts include financial covenants that require firms' performance metrics to meet certain thresholds, so higher interest expenses can lead to firm distress and, if the covenants are violated, actual defaults." A new analysis by the Federal Reserve Bank of Kansas City[4] provides precise estimates of the significant amount of fixed-rate debt that will mature in the next years. This loan will have to be refinanced at much greater rates than before. Despite this, the authors state that "most firms have healthy interest coverage ratios, suggesting they can likely weather higher debt servicing costs as long as their earnings remain stable." The term 'as long as' emphasizes the interdependence of policy rates, borrowing costs, firm sales and earnings, interest coverage, hiring decisions, and so on.
When you combine these considerations with the delayed pass-through impacts of previous rate hikes and the variety across companies in terms of financial resilience, it's evident that determining whether the current resilience will persist is a significant issue.
A recent Federal Reserve publication[5] contributes significantly to the explanation. It employs interest coverage ratios (ICRs) to evaluate the sensitivity of U.S. nonfinancial public firms to several macroeconomic scenarios developed by Moody's, taking into account projections of corporate earnings growth, Treasury yields, bond spreads, the federal funds rate, the growth of corporate bonds and loans outstanding, as well as the debt maturity structure and thus future refinancing needs of firms. PERCENTAGE OF DEBT AT RISK FOR US-LISTED NONFINANCIAL FIRMS The authors conclude that, due to strong balance sheets and moderate short-term refinancing needs, "the debt-servicing capacity of the U.S. public corporate sector as a whole is robust to sustained elevated interest rates, both in the soft landing (baseline) scenario as well as in a stagflation scenario with a moderate economic downturn." This also applies, on average, to non-investment grade companies. However, a severe economic downturn would, through a steep decrease in incomes, "lead to a substantial deterioration in the projected aggregate ICR to levels similar to those observed in the 2008-09 and 2020 recessions" (graph). Finally, focusing on enterprises with already poor balance sheets, continuously rising interest rates would cause a significant deterioration in credit quality. It would also include "some large investment-grade (IG) firms that have so far been relatively insulated from rising rates by their high share of fixed-rate debt." In this scenario, the share of debt at risk[6] would rise steadily over the following two to three years, even if incomes were stable.
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