A new study by S&P Global Ratings finds that lower-rated speculative-grade U.S. corporate issuers are most vulnerable to a higher-for-longer interest rate environment. Specifically, we expect the sharp rise in debt service costs, weak interest rate hedging policies, and ongoing free operating cash flow deficits to narrow liquidity cushions for many 'B' and 'B-' rated issuers in 2023.
- Issuers rated 'B' and 'B-' are highly exposured to unhedged floating rate debt obligations, and thus could see 60 basis points (bps)-80 bps increase in interest costs for every 100 bps in higher benchmark interest rates.
- We expect the realized quarter over quarter (QoQ) impact on higher interest rates to jump just over 10% in the fourth quarter of 2022 and about 7.7% in the first quarter of 2023.
- In our 2023 stress scenario analysis, we estimate median interest coverage ratios for 'B' and 'B-' issuers could fall by about 0.52x to 0.66x, and the percentage of these issuers with negative interest coverage ratios could rise to the low 20% area from 15%.
- 'CCC' category downgrade risk resulting from higher-for-longer interest rates is highest in the Health Care Equipment and Services, Software and Services, and Commercial and Professional Services industry groups.
- Smaller issuers with EBITDA of less than $75 million are seeing higher interest coverage ratio weakness.
This study utilizes a sensitivity analysis on more than 1500 speculative-grade issuers to various interest rate and EBITDA margin scenarios to estimate interest coverage shortfall risk. Our observations are founded on understanding the correlation between the change in benchmark interest rates (e.g., LIBOR, SOFR) and reported interest expense in the third quarter of 2022 (2022 Q3). Additionally, we reviewed interest rate hedge disclosures within the financial statements of 173 speculative-grade issuers (slightly more than 10% of the speculative grade portfolio) to corroborate our assumptions. Our analysis recasts 2022 Q3 financial results to estimate the proportion of issuers at risk and sectors with elevated rating pressure.
The lagged impact of higher benchmark interest rates will take an increasingly greater bite out of cash flows this year. We expect the lagged effects of the sharp tightening of monetary policy to be increasingly realized quarter-over-quarter (QoQ) through mid-2023. Despite market expectations that benchmark rates will decline modestly by May 2023, the U.S. speculative-grade portfolio will likely see higher QoQ debt service cash outflows through the second quarter since interest is often paid at the end of the period. If benchmark rates are similar to Federal Reserve Board members' 2023 central tendency projections (proxied by the March 1, 2023, SOFR forward curve), we could see higher QoQ cash outflow through year-end (Chart 1).
U.S. speculative-grade issuers saw a 10.9% median percentage increase in generally accepted accounting principles (GAAP)-reported interest expense to debt QoQ in 2022 Q3. On an annualized basis, the portfolio median reported interest expense to debt grew to 6.74%. 'B-' and 'B'-rated issuers saw a 14.5% and 12.9% rate of change increase, respectively. Accordingly, it could pose a downside risk to the ratings of these issuers because a significant number of these issuers have continued to realize cash flow deficits through 2022. The higher rate of increase primarily reflects modest hedging policies and high exposure to floating rate debt compared to higher rated issuers.
For each 100 basis points (bps) increase in the benchmark interest rates, we expect approximately 60 bps-80 bps passthrough of costs for 'B' and 'B-' rated issuers. Our estimate is based on the triangulation of two distinct datasets. In 2022 Q3, the U.S. corporate speculative-grade portfolio saw a median passthrough of interest expense of about 48 bps for every 100 bps of benchmark rate increases. 'B-' issuers saw the highest passthrough at 71 bps while 'B' issuers saw 59 bps (Chart 2). Issuers rated 'B+' and higher are better positioned to weather higher rates given their higher percentage of fixed-rate debt capitalization and better hedging policies.
To corroborate our passthrough estimate and better understand why the impact differs for issuers in different speculative-grade rating categories, we reviewed the financial statements of a random sample of 173 speculative-grade issuers to quantify the exposure to rising interest rates. The results for issuers rated 'B+' and higher are generally similar; however, we see more variability with issuers rated 'B-' or in the 'CCC/CC' category (Table 1). Accordingly, in our following stress tests, we used an average of our two studies, 75 bps benchmark rate flow-through for 'B-'issuers.
|Implied Higher Benchmark Rate Passthrough By Rating Category|
|Rating Category||Sample Size||% With Interest Rate Hedge?||If Hedged, % Floating Debt Hedged||% Floating Rate Debt Capitalization||Implied Benchmark Rate Passthrough|
|Note: Based on a random sample of 173 U.S. speculative-grade issuers. Document review to determine the level of interest rate hedges included an analysis of 2021 annual or 2022 quarterly financial statements. Source: S&P Global Ratings.|
'B' and 'B-' issuers could see a 0.50x-0.75x decline in reported EBITDA interest coverage ratios if EBITDA margins remain unchanged and the benchmark rates remain in the 4%-6% range. In Table 2 we detail the results of our study, where we stress reported EBITDA margins and the annualized benchmark rate to assess their impact on reported EBITDA interest coverage ratios for 'B' and 'B-' issuers. The analysis assumes revenues remain unchanged and excludes refinancing transactions that result in higher credit spreads. For example, assuming reported median EBITDA margins remain the same at 14.4% (as of 2022 Q3), a 60% and 75% benchmark rate flow-through for 'B' and 'B-' issuers (respectively), and 4% annualized benchmark rates, we estimate a 0.52x (2.21x minus 1.69x) reduction in interest coverage. In this scenario, the percent of 'B' and 'B-' issuers with reported interest coverage less than 1x increases to 22% from 15% in 2023 Q3.
Alternatively, a 10% decline in reported EBITDA margins and 4% annualized benchmark rates could result in a 0.68x reduction (2.21x minus 1.53x) in reported interest rate coverage ratios with the percentage of 'B' and 'B-' issuers with negative interest coverage ratios rising to 25%. In the worst-case stress scenario (EBITDA margins fall 15% and 6% annualized benchmark rates), the percentage of issuers with negative interest coverage ratios rises to 35%.
In a higher-for-longer interest rate environment, the most vulnerable 'B-' issuers are in the Health Care Equipment and Services, Software and Services, and Commercial and Professional Services industry groups. To identify industry sectors with increased 'CCC' category downgrade risk, we stressed reported interest coverage for 'B-' issuers assuming that reported EBITDA for the 12 months ended Sept. 30, 2022 remains unchanged. The color scale in the chart below reflects the percentage of issuers with reported interest coverage of less than 1x. For example, in a scenario where the annualized benchmark rate is 4%, we could see more than 30% of 'B-' issuers in the six vulnerable industry sectors with negative interest coverage ratios.
Issuers rated 'B' and 'B-' with less than $75 million EBITDA report weaker interest coverage ratios. We believe smaller issuers have underperformed larger issuers because they have struggled to pass through high input costs and manage supply chains. Furthermore, smaller-scale issuers will likely be the first to realize earnings stress in a declining macroeconomic environment.
Data and Methodology
We use last 12 months (LTM) GAAP-reported income and interest expense data for U.S. and Canadian corporate speculative-grade issuers.
The study emphasizes the importance of reported cash flow generation given these issuers' relatively weak liquidity profiles and underemphasizes the expected performance improvement in our rating assessment. Furthermore, we apply the same stress level to each issuer regardless of offsetting factors.
Reported financial statements typically include transaction fees and restructuring expenses as operating costs, which may significantly reduce EBITDA. Additionally, LTM operating results may not include a full year's contribution from acquisitions made in the prior 12 months but do include all debt financings. Lastly, our stresses do not account for companies' ability to reduce costs and manage cash flow pressures over the coming periods.
This report does not constitute a rating action.
|Primary Credit Analyst:||Minesh Patel, CFA, New York + 1 (212) 438 6410;|
|Secondary Contact:||Steve H Wilkinson, CFA, New York + 1 (212) 438 5093;|
|Research Assistant:||Renuka Kumar, Pune|
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