Falling interest coverage ratios threaten HY refinancings

6 min read
Lorena Ruibal

Increased borrowing costs are hindering companies’ ability to service outstanding debt from earnings, creating a risk for rating downgrades and defaults as they lose access to debt capital markets.

After a decade of ultra-low interest rates, borrowing costs have shot up in the aftermath of the coronavirus pandemic as central banks embarked on a series of interest rate rises to bring down inflation from multi-year highs. While price pressures have moderated in the last months, inflation remains above central banks’ targets, indicating they may continue to lift base rates as the economy slows, hurting earnings prospects.

“Higher rates raise the question around a business model sustainability,” said Brian Kloss, portfolio manager at Brandywine Global. “In some cases, if we don’t have a rates cutting cycle, it could mean that the capital structure isn’t sustainable, even if it’s a very good business model.”

Riskier companies are more vulnerable. Coverage ratios are typically thinner for those carrying lower ratings due to their higher leverage and risk premiums, according to research from Commerzbank, showing that coverage ratios hover around the low-to-mid single digits on average for Single B rated firms, increasing to low-to-mid teens for investment-grade companies.

“Broadly speaking, anything that’s a Single B or below, a substantial proportion will be levered cashflow negative at the new cost of debt given that the cost of debt has doubled," said David Nazar, founder and chief investment officer of Ironshield Capital Management, adding that their capital stacks don't probably work now.

"Some will be made to work, others will get restructured, but this is happening because of the change in risk-free rates.”

High-yield companies face shorter maturities, which makes them more reliant on debt capital markets to push out repayment deadlines and stay afloat. Also, they typically have a higher share of floating-rate debt, making them more vulnerable to surging interest rates.

“It's a new world we're entering, right now everybody's looking more at interest cover ratio than leverage ratios because a lot of these companies are struggling to service their debt at that level of costs,” said one senior leveraged finance banker.

There are some €153bn of European junk-rated debt, including bonds, loans and revolving credit facilities, maturing in 2023 and 2024 as of January, according to S&P data.

"Higher interest rates eat into their fundamentals at a much faster pace”, creating a "coupon time bomb", credit strategists at Commerzbank wrote in a note.

But even if there is a let up in rates, the scale of the increase means that many companies will still see a meaningful uptick in their interest costs.

"Let's say [a small high-yield company] issued at 5% seven years ago, and they have to issue at 10%, their interest expense goes up significantly," said Kloss.

It would be even worse for the lowest-rated issuers. While the market is closed currently for Triple-C companies, once it opens, the cost of issuance could well be in the low to mid-teens and "then the equity starts to become impaired," said Kloss.

'Painful refinancings ahead'

He sees more restructurings down the road. "It will be interesting to see if we get more debt-for-equity swaps, some out of court restructurings. And how it all ends up depends on whom the bondholders are.”

Activity in the new issue high-yield market has been dominated by refinancings this year, with coupons more than doubling depending on the issuer and rating compared with those on the debt being replaced, illustrating a substantially higher interest burden for the better-rated high-yield firms.

For instance, last month Double-B rated Energia issued a €600m 6.875% five-year non-call two bond to refinance the company's £225m 4.75% September 2024 and €350m 4% September 2025 bonds. Also in July, Single B rated Telecom Italia printed a €750m 7.875% five-year senior unsecured note to take out 3.625% notes due January 2024 and 4% bonds due April 2024 via a tender offer.

The average yields of new issue euro bonds rated Double B and Single B is well above the average level between 2016 and 2021 and will increase further going into 2024, pointing to “painful refinancings ahead," Commerzbank's credit strategy team said.

The yield on the ICE BofA Euro High Yield Index was quoted at 7.21% on Monday morning, up from 2.37% two years ago, according to Refintitiv data.

A weaker growth outlook coupled with higher borrowing costs is now widely expected to drive up defaults in the coming quarters.

Fitch forecasts the trailing 12-month European high-yield bond default rate is set to jump to 2.5% from 1.6% by the end of 2023, climbing to 4% by the end of 2024 due to a higher number of issuers with unsecured instruments in cyclical sectors.

Meanwhile, Moody’s expects global high-yield corporate defaults to peak at 5% by the end of April 2024, from 3.4% in May.

Cutting down debt

Still, some companies have started taking action, focusing primarily on cutting down their debt loads.

Israeli generic drugmaker Teva Pharmaceutical Industries's management said it intends its reduce its net debt-to-ebitda ratio to 2x by end-2027, as its recent debt refinancing leads to a higher interest expense, Lucror Analytics wrote in a recent note.

UK sportscar maker Aston Martin Lagonda is taking a different approach, using proceeds from a rights issue to redeem the US$236.1m outstanding of 15% second-lien notes due 2026. It's targeting a debt reduction to 1.5x in 2024–25 from 4x at the end of the first half of this year, Lucror noted.

(additional reporting by Helene Durand)

Updated story: Adds investor comments