Junk-rated US companies are facing increased financial pressure as the Federal Reserve's rate hikes have led to rising interest costs, without a corresponding increase in profits. This situation highlights a significant risk for investors in high-yield debt, especially if the trend continues.
The gap between companies' earnings and their interest expenses has widened, reaching its lowest point since the pandemic. The median debt-service coverage ratio in the leveraged-loan market has dropped to just 3.5 times, down from over 5 times a year earlier. This decline is a direct result of the Fed's aggressive measures to combat inflation, which have included raising its benchmark rate by approximately 5 percentage points since 2022.
Despite expectations of a future rate cut, Fed Chair Jerome Powell has been cautious about specifying when rate reductions might begin. This suggests that borrowers will continue to face challenges from high interest rates even after the current rate-hike cycle ends. A debt service coverage ratio below 2 times often indicates difficulties in refinancing maturing loans and bonds, potentially leading to ratings downgrades or corporate defaults.
The US leveraged loan default rate has slightly increased, nearing levels observed during past recessions. This uptick underscores the ongoing stress from higher capital costs. However, the market has shown some resilience, with loan prices remaining relatively high. Still, concerns are evident as leveraged loan prices saw their most significant drop in five months following the latest Fed meeting.
The situation is particularly challenging for loans compared to high-yield bonds due to their floating-rate nature, which results in quicker adjustments to interest costs in a rising rate environment. This has led to more downgrades and slightly higher defaults in leveraged loans.
Borrowers with fixed-rate debt are not immune to these pressures, as they will face similar challenges when it's time to refinance, especially if the rate environment remains unchanged. Portfolio managers caution that borrowers must actively manage their leverage to maintain adequate coverage ratios, or they risk facing intensified stress.
