A Big Chunk Of Debt Is At Risk Of Default

A Big Chunk Of Debt Is At Risk Of Default
Stéphane Renevier, CFA

6 months ago2 mins

As the Federal Reserve's (the Fed’s) turbo-charged interest rates start revving up expenses for companies, you may want to brace yourself for a wave of defaults.

US companies surprisingly haven’t seen their loan payments soar, even with the Fed hiking interest rates like there’s no tomorrow. That’s because much of corporate America managed to lock in long-term debt at low, fixed rates. Basically, they slathered themselves in financial sunscreen, shielded from the Fed's rays.

Alas, no sunscreen lasts forever. Those fixed-rate corporate bonds will eventually mature, and when they do, companies will face the glare of higher borrowing costs. And with so many firms in the market for new financing right now, that’ll only amp up the heat. See, with interest rate hikes, the effects are a slow burn: Fed data shows that interest payments usually hit their peak about five quarters after the initial rate hike. And that means companies are only just beginning to see their interest costs swell.

It’s part of the reason why I’m keeping an eye on the interest coverage ratio (ICR). It’s like a corporate gut check, measuring how easily a company can cover its interest payments from its profits. And this isn't some nerdy metric you can ignore; it's a make-or-break number with real economic implications. If the ICR dips below a certain level, a company might breach the terms of its loan agreements – known as "financial covenants". A breach might mean the lender can demand immediate repayment, renegotiate the terms of the loan (at higher rates, obviously), or worse, take control of the firm.

As you can see in the chart, the Fed calculated that nearly a third of total debt is teetering on the edge of that kind of default. When defaults turn into bankruptcies, that’s when the dominoes really start to fall. Lenders might hit the "risk-averse" button, making it harder to borrow. Companies, in turn, could cut back on both hiring plans and investment dreams, kicking off a vicious cycle of credit tightening and economic slump.

Of course, if the economy keeps flexing its muscles, companies might still make enough moolah to cover those ballooning interest costs. So it might not be an economic apocalypse, but let's not kid ourselves here, those higher interest rates are a ticking time bomb you’d be wise not to ignore.

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