The US economy may be growing much faster than pessimists had predicted, but business is still brisk for bankruptcy lawyers. “Things have really accelerated,” says Thomas Lauria, global head of restructuring at White & Case. His team is on track for record-breaking revenues this year.
Meanwhile, hedge funds are spying opportunities ahead as companies are forced into financial restructurings that could see debt change hands for well below its face value. Buyers of that debt could make big gains if the company goes on to make a recovery. “It’s going to become more of a credit-picker’s market,” predicts Mike Scott, head of global high-yield and credit opportunities at Man Group GLG.
Such activity is a sign that a new era of high borrowing costs is starting to bite in corporate America, whose overall borrowings now total $13tn according to Federal Reserve data. Businesses that grew accustomed to cheap debt during more than a decade of ultra-low interest rates must now adjust to a world where financing costs more.
A lot more; since March 2022 the Federal Reserve has raised interest rates from near-zero to a range of 5.25 to 5.5 per cent. The European Central Bank, the Bank of England and others have followed suit. Even though the Fed and the BoE holding rates this week suggests the interest-rate cycle may have peaked, many expect borrowing costs to remain high.
If that is the case, then more companies are going to need to either repay their loans, or refinance them at substantially higher cost. Over $3tn of corporate debt is due for repayment over the coming five years.
“So many companies have really benefited greatly from the zero cost of capital,” says Greg Peters, co-chief investment officer at PGIM fixed income. “You’ll be in this persistently higher-than-normal distressed default environment as a consequence.”
In addition to raising finance costs, higher rates may also dampen the spending power of consumers. Investors are starting to fret that this one-two punch could trigger a wave of debt defaults, possibly leading to more company failures and job losses.
Moody’s, the rating agency, says global default rates on riskier debt reached 4.5 per cent over the year to September, above the historical average of 4.1 per cent.
In the US, the rate has climbed to 4.9 per cent, with casualties this year including car dealership Carvana, National CineMedia and infrastructure services group QualTek. Moody’s predicts the US default rate will peak at 5.4 per cent by January, but if conditions worsen it could soar as high as 14 per cent.
Market participants say that defaults so far have been primarily driven by business- and industry-specific issues. “For the most part, [tighter monetary policy] has been a compounding effect for companies that were otherwise struggling,” says one senior restructuring lawyer.
“They just haven’t recovered in terms of business performance and profitability — and now they’ve got the interest burden on top . . . it’s creating a tremendous amount of liquidity pressure.”
These defaults are already having a stark human cost. In April, the 52-year-old retailer Bed Bath & Beyond finally succumbed to bankruptcy, after refinancing its debts nine months earlier. Almost 500 stores are closing, and 14,000 people losing their jobs.
In a possible sign of more defaults to come, Moody’s “B3N negative and lower” roster — a distressed debt watchlist — rose to 240 companies during the third quarter of this year, up from 177 companies a year ago.
Companies have responded to rising borrowing costs by extending the maturity profile of their debt, offering additional collateral in return for lower interest rates or tapping newer sources of borrowing, such as the private debt market.
Those that have run into trouble have pursued resolutions other than traditional insolvency in an attempt to buy more time for restructuring.
But an extended period of more subdued demand and elevated financing costs could still spell trouble for many. “Interest rates are simply biting harder and harder, and having more significant implications,” says Torsten Slok, chief economist at investment firm Apollo.
“The most highly levered companies are going to be more vulnerable.”
If the pressure on corporate borrowers wasn’t high enough already, last month the yield on 10-year US government bonds exceeded 5 per cent for the first time since 2007.
Average funding costs for the $8.6tn market in the highest quality corporate bonds, known as investment grade, are now above 6 per cent, according to Ice BofA data. Although that is three times their lows of below 2 per cent in late 2020, market participants are relatively sanguine about the health of these high-quality companies.
“They have smaller debt stacks [compared to] the size of their overall capitalisation. They’re less levered,” says Maureen O’Connor, global head of Wells Fargo’s high-grade debt syndicate.
There is more concern about less creditworthy borrowers in the $1.3tn non-investment grade market, often called junk or high-yield. Coupons now average 9.4 per cent, more than double their lows in late 2021. The picture is similar in Europe.
“When interest rates are 1 or 2 [per cent] you can incur a lot of debt and you can afford the debt service,” says Lauria at White & Case. “When they go up to 5, 6, 7, 8, 9, 10, things become more challenging.”
Bond yields in that territory are cheering for investors after years of meagre returns, but they are a burden for smaller companies in particular. A recent survey by the National Federation of Independent Businesses showed that US small-caps were paying almost 10 per cent interest on short-term loans in September, up from lows of 4.1 per cent in mid-2020.
Higher rates have put a stop to most debt-backed buyout activity and made refinancing existing borrowings more challenging. Sub-investment-grade companies carry more credit risk, reflected in the higher interest costs of their debt, and have almost $570bn of bonds maturing over the next five years.
But roughly half of this market is rated BB or equivalent — the highest rating outside of investment grade, leaving PGIM’s Peters to quip that the so-called junk bond market “is a lot less junky these days”.
“[Leverage] has been pulled out of the high-yield bond market and put into the leveraged loan market and private markets,” he adds.
It is these markets where concerns are most acute. Leveraged loans are typically raised by heavily indebted companies with low credit ratings and their coupons move up and down with prevailing interest rates.
Leveraged loans grew rapidly during the era of cheap money, becoming a mainstay for risky borrowers and debt-financed buyouts. At $1.4tn, the US leveraged loan market is now worth slightly more than its high-yield bond market and accounts for much of the non-investment grade debt that is due to mature over the coming five years.
But as the Fed has tightened, loan issuers have felt the pain of rising borrowing costs much more quickly than their counterparts in the fixed-rate bond market, and warning signals about issuers’ ability to service their debts are already flashing.
Cash interest coverage on newly issued loans had dropped to 3.16 times by the end of the third quarter, its lowest level since 2007 if compared with previous full years. Interest coverage has also declined for existing loans, data from PitchBook LCD shows, signalling that earnings are not growing quickly enough to keep pace with rising borrowing costs.
Leveraged loans are mostly bought by so-called collateralised loan obligations, which package up the loans and sell them on as investment products spanning different credit ratings. But they cannot hold large amounts of very risky debt, such as that rated CCC or below.
A flurry of downgrades to that rating could trigger a process that cuts off cash flows to the lowest tier of investors in the CLO. Many CLOs are also exiting their so-called “reinvestment periods” this year — the timeframe over which they can buy new debt — potentially further shrinking demand for leveraged loans.
Investors and analysts expect higher-for-longer rates to expose businesses whose underlying weaknesses have been masked by easy access to cheap money.
“We’re seeing quite a few companies that have very heavily leveraged balance sheets, who are concerned — and their counterparties are concerned — about their ability to refinance that debt as it matures,” says Lauria.
PGIM’s Peters expects a “natural Darwinian winnowing out process” rather than a “cataclysmic type of situation”. But Slok, at Apollo, says a few high-profile casualties could have an outsized impact. “If [interest rates] stay at these levels for the next nine months, you will begin to have household names in the high-yield index begin to be at risk of defaulting,” he says.
“People would start looking at credit metrics for companies that are similar and begin to ask the hard questions”
The riskiest borrowers — those rated CCC and below — in the high-yield bond market are already paying 10 full percentage points more than government bonds of comparable maturity, more than double the average spread for all high-yield of just over 4 points.
Services, consumer products and healthcare have dominated Moody’s B3N register. Healthcare companies have already been hit by lower reimbursement rates and rising staff costs, and many are backed by private equity firms that loaded them with borrowings when debt was cheap.
Just this month, for example, helicopter ambulance company Air Methods filed for Chapter 11 bankruptcy, citing its “unsustainable” debt load and the “strain caused by tightening financial markets” as contributing factors.
How borrowers responded
Many corporate treasurers took advantage of cheap money when rates were low to push out debt maturities, giving themselves breathing room for tougher funding environments.
During 2021, as the mood music on interest rates began to change, there was a frenzy of borrowing on seven-year tenors, with the result that the amount of debt due to mature peaks in 2028, though it will rise each year up until then.
In the loan market, a trend towards refinancing several tranches of debt in one agreement when the first tranche matures could mean maturities are moved forward and refinancing risks increased, according to Moody’s.
Market participants agree that many companies will survive tougher credit conditions, a sentiment reflected in the premium paid by high-yield borrowers in the US and Europe over their government equivalents. The so-called spread is narrower than it was earlier this year in both the US and Europe.
Andrzej Skiba, head of Bluebay US fixed income at RBC Global Asset Management, predicts “a pretty benign default cycle” for US junk bonds, partly because many “old economy” companies that were struggling a few years ago chose to restructure in 2020. “That was like a washout event for the asset class,” he says. “You have very few problematic names on the horizon.”
Businesses facing refinancing have already shown resourcefulness in blunting the impact of higher interest rates. Some high-yield bond issuers have pledged collateral, giving lenders enhanced security over their assets or cash flows in return for lower borrowing costs.
Those that had borrowed at low rates have also tried to push deadlines for repayment further out in to the future. “We had a lot of ‘amend and extends’ in September in the loan market,” says Nick Kraemer, head of ratings performance analytics at S&P Global Ratings, “but not necessarily a lot of defaults.”
Companies arranging new debt have shortened the windows over which they borrow to avoid locking in high yields.
But creative financial engineering has also altered the composition of defaults. Many borrowers are now opting for so-called distressed exchanges, reaching agreements that involve creditors receiving assets worth less than the face value of bonds or loans rather than resorting to expensive bankruptcy proceedings.
“If we look at the first three-quarters of this year, distressed exchanges comprise roughly two-thirds of all corporate family defaults in the US,” says Julia Chursin, senior analyst at Moody’s. She adds that “the majority of them — 78 per cent — were done by private-equity owned companies”.
Distressed exchanges can be more appealing to private-equity firms, because they often leave a creditor company’s equity less impaired. But several recent distressed exchanges have simply kicked the can down the road towards another default.
Historically, says Chursin, half of all issuers who chose distressed exchanges have ended up seeking another restructuring or, like Bed Bath & Beyond and healthcare provider Envision, filed for bankruptcy. “Whether it’s another distressed exchange or a bankruptcy, it is still a haircut for investors,” she adds.
Public markets, in which parcels of debt can be traded, are not the only option for companies trying to refinance or simply avoid default. Private credit, where specialist firms lend directly to borrowers, has exploded in size; UBS put its value at $1.55tn earlier this year, up from $1tn in 2019.
Already, businesses ranging from tech company Hyland Software to shoemaker Cole Haan have refinanced their debt with new loans from private debt this year.
Negotiating with just a handful of lenders rather than a big syndicate can be quicker, easier and bring more certainty of a deal getting over the line, said analysts and investors. But if a creditor company fails to recover, its fate rests in the hands of that same small handful of lenders, rather than a bigger group of investors — a situation that could limit the range of avenues still open to the troubled borrower.
Lending standards also tend to be more exacting, while companies backed by private credit “are still dealing with the same macro environment that everybody else is”, notes S&P’s Kraemer. And with no publicly visible pricing, mounting stress in private debt is hard for investors to track.
For Bluebay’s Skiba, “the clock is ticking” in both the leveraged loan and private credit markets. “One or two fires” in a portfolio might be containable, he says, but distress on multiple fronts could easily lead to a situation “where some of those owners say ‘I just can’t inject equity everywhere, I cannot just provide new cheques to those portfolio companies right, left and centre.’
“That’s when you have accidents occurring. That’s when you have the default rate picking up.”