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LIBOR: Shipping's elephant in the room

The shipping industry’s vessel loans are typically taken on the basis of a premium over LIBOR. LIBOR has been experiencing upward pressure since early 2017, as major central banks have moved to a tightening stance. The three-month LIBOR has risen to 2.3% as of April 2018, the highest rate seen since November 2008, the early days of the financial crisis.

As LIBOR increases, stresses on shipping industry balance sheets, cash flows and earnings also rise. With rates still at relatively low levels in historic terms, further increases are likely, and for a highly capital-intensive sector like shipping, this will undoubtedly weigh heavily on already debt-laden companies.

To get an idea of just how much leverage the shipping sector is exposed to in the context of the wider economy, we used the median leverage ratio for S&P 500 companies as a baseline and compared it to the leverage ratio for shipping players as listed on S&P Global Market Intelligence’s platform. The difference between the two is startling: while the median net debt to EBITDA of S&P 500 firms is 1.5x, the rate for shipping firms is around 8.0x

Another solvency measure commonly used is the Interest Servicing Coverage ratio, which is EBIT over interest expense. A higher figure indicates a stronger debt repayment capability. The mean ISC ratio for shipping firms listed on S&P Global Market Intelligence’s platform was around 0.6x, sharply lower than the S&P 500 mean of 5.5x. Though the shipping companies included on the S&P Global Market Intelligence platform are typically larger, publicly listed entities, it is clear that smaller shipping players will also feel similar stress.

Information produced in the IMF's Global Financial Stability Report in April 2017 demonstrates that a marginal increase in lending rates can lead to disproportionally higher pressures on corporate debt servicing. This means that a 1% increase in LIBOR would in general contribute to roughly more than a 10% increase in a company’s interest cost as a share of its operating income.

Shipping companies have accumulated more debt in recent years to fund a strong appetite for newbuild vessels, as well as mergers and acquisitions. Among the publicly listed companies in the sector, there are a substantial proportion of junk rated entities: 15 of 17 shipping firms have been given a speculative grade by S&P Global Ratings as of February 2018. Notably, these companies all have particularly weak leverage factor scores, which contribute a substantial proportion of the final rating.

In view of mounting debt, bond investors could demand higher interest rates, fueling further distress among shipowners. Similarly, an exogenous shock could precipitate a repricing of risk premiums, which could lead to further downgrades by rating agencies.

Are these unwarranted concerns over systemic risk, when the global economy is progressing toward the late end of the cycle, or is LIBOR the elephant in the room? Only time will tell.

Overall, despite recent recoveries in some shipping sectors, lackluster freight rates remain a drag on many highly leveraged businesses and it is uncertain whether freight earnings would be able to outpace higher financing expenditures moving forward.