As interest rates soar and the economy cools, can corporate America pay their debts?

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Welcome to the US corporate debt market in 2022.

Often the only risky bonds that are issued are debts inherited from a seemingly ancient era, when interest rates were low and a recession was unthinkable.

Elsewhere, the high yield market has almost come to a standstill. A meager US$83 billion (NZ$133 billion) of risky debt has been issued so far in 2022, down 75% from the same period last year.

A sharp rise in interest rates in the first half of this year chilled credit markets, caught investors on the wrong foot and complicated life for bankers.

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In January, Bank of America, Credit Suisse, Goldman Sachs and a handful of other banks agreed to fund a $15 billion deal for two private equity firms to buy Citrix, a software company.

They promised to issue the riskiest US$4 billion of this debt at a maximum interest rate of 9%. At the time, the average yield on bonds with a ccc credit rating, a speculative rating, was around 8%.

The average coupon on an investment-grade bond is just 3.6%, half the rate in the early 2000s and still below the 2019 level. This will insulate borrowers as rates rise.

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The average coupon on an investment-grade bond is just 3.6%, half the rate in the early 2000s and still below the 2019 level. This will insulate borrowers as rates rise.

The Citrix deal is expected to close sometime in July. If the bankers cannot sell the debt below the interest rate ceiling, they will have to pay the difference.

But the yield on ccc-rated bonds soared above 14%, making it difficult for banks to sell debt to investors below the cap.

“If the market looks like it is today, these banks are going to lose hundreds of millions – and potentially a billion dollars on this transaction alone,” says Roberta Goss of Pretium, head of debt investments.

The stakes overall are much higher. A steady decline in interest rates over the past 30 years has prompted businesses to borrow record amounts.

Now the cost of servicing and refinancing this mountain of debt is climbing, profits are being eroded by rising costs, and inventory is piling up at some businesses as demand slows. Is a corporate debt meltdown imminent?

The last major US debt crisis, in 2007-09, was in housing. The stock of household debt relative to GDP had risen sharply as lenders issued mortgages aggressively and house prices soared.

When interest rates rose, borrowers began to default. Some three million households were eventually seized in 2008.

This time around, households seem much less likely to be the troubled borrowers. Lending standards have been tightened and debt levels have fallen. Household debt to GDP peaked at 99% in 2008, but has since fallen to just 75%. In contrast, corporate debt as a percentage of GDP, at around 80%, has reached or approached record highs over the past two years.

To understand where problems may arise, it’s important to look at the many financing options available to businesses and their owners. American companies owe about $12.5 billion.

Some US$6.7 trillion is in the form of bonds, mostly issued by large or medium-sized public companies. An additional US$1.3 billion corresponds to bank loans and another US$1.1 billion to mortgage debt. The rest – over US$3,000,000 – is non-bank financing, consisting mostly of private credits, usually loans made for equity buyouts, or “syndicated” loans, which come from banks but are divided into pieces and sold. to investors, or sometimes bundled into other debt securities.

The bond market, as the main source of debt, may seem like the natural place to look for trouble.

But companies that issued bonds are “relatively gaining” from rising interest rates, says Eric Beinstein of JPMorgan Chase in New York, US, because most bonds pay fixed coupons.

Of the US$5,000,000 of corporate bonds issued since the start of 2020, around 87% pay fixed coupons. And these coupon rates are at historic lows. The average coupon on an investment-grade bond is just 3.6%, half the rate in the early 2000s and still below the 2019 level. This will insulate borrowers as rates rise.

These fixed rate bonds will also not mature soon. The riskier high-yield end of the bond market — the roughly US$1.5 billion owed by below-investment-grade issuers, which are typically smaller or highly indebted companies — has seen a wave. refinancing in 2020 and 2021.

The result is that only a tiny $73 billion of high-yield bonds will mature in 2022 and 2023. The peak of risky bond maturation won’t come until 2029.

The impact of rising rates is likely to be much greater in the syndicated loan and private debt markets, which typically issue floating rate debt (although some of this rate risk may have been covered).

They have also experienced explosive growth. Between 2015 and 2021, the value of outstanding high yield bonds increased slightly, from around $1.3 billion to $1.5 billion. In contrast, syndicated loans fell from US$900 billion in 2015 to US$1.4 billion over the same period.

Private credit was weakest in 2015, with just $500 billion in assets under management. Today, with $1.1 billion in assets, it rivals its other venture debt peers.

John Kline of New Mountain, a private credit company in the United States, says private credit’s growing market share reflects the fact that it offers issuers price certainty and is “much easier to manage” than arranging a bank loan. through a syndication process or through the issuance of a bond. He points out that the barbaric days of private equity shops taking advantage of companies with 85% debt to total value are long gone.

Last year, the average debt-to-value ratio of private equity deals was closer to 50%.

Yet this ratio is less reassuring considering how far private equity valuations may have fallen this year (official numbers are rarely revised, unlike public market valuations). And with strong growth seems to have come new risks.

Compared to the profits of the companies they acquired, debt levels look much higher: equal to an average of six times gross operating profit, a little higher than the record set in 2019 or during one of the last 20 years.

“Anytime a market is growing rapidly, there can be some kind of awareness if the environment changes,” Beinstein says.

The challenge, he says, is obtaining details or data on private transactions. In the bright light of public markets, it’s easy enough to find evidence to suggest companies aren’t facing an impending crisis. The problem is that part of the debt hides in the shadows.

© 2022 The Economist Newspaper Limited. All rights reserved. Excerpt from The Economist published under licence. The original article can be found at www.economist.com

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