Evening Brief – 06.06.23

The cost of servicing debt for corporations with poor credit ratings has ballooned, reaching levels not seen in over a decade. This increase can be attributed to the Federal Reserve’s restrictive monetary policy. And it could force some businesses to reconsider their capital structures and place a greater emphasis on protecting cash flows.

Bloomberg cited a report by S&P Global Ratings that stated junk-rated companies are paying an effective rate of 6.1% on debt, up from 5.1% the previous year. The 6.1% interest rate is the highest since 2010.

“We could see greater efforts to reduce net debt, more use of equity in M&A, and more caution over capital expenditure,” said Gareth Williams, head of corporate credit research at S&P.

Junk-rated firms will need to reevaluate their business strategies developed during a low-rate environment, as the era of cheap money has been over for 14 months and is likely to continue to be over for a while as the Fed battles inflation.

High-yield corporations face the double whammy of high and rising payments from variable-rate debt and declining earnings. Developers, homebuilders, healthcare, aerospace and technology firms have some of the greatest increases in interest paid relative to total debt.

The decade of expansion fueled by debt has abruptly ended, which is bad news for zombie businesses. Credits with capital structures designed for a world of near-zero interest rates that are more susceptible to default will make the transition problematic. These firms with a poor credit rating will need to eliminate debt and slow their growth.

S&P warned late last year that even a mild recession would result in a cascade of corporate defaults. According to the ratings agency, the default rate for US companies could reach 3.75% by September if the Federal Reserve’s hawkish policy causes a shallow or moderate economic recession. In a more dire scenario, the default rate could reach 6%, the highest level since March 2021.