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Written by: Len Reininger | Advisor Asset Management
With a growing number of economists forecasting a stronger U.S. economy next year on the back of strengthened retail sales and a smaller rise in unemployment while, at the same time, avoiding numerous potential dangers thus far in 2023, it would be easy to become more complacent in terms of corporate default rate expectations.
Even the rating agencies have modified their base case scenarios. Moody’s, while noting that the default rate has risen to 4% in July, will — in their base case scenario — peak at 4.7%, down from 5.1% just last month. So, can we breathe a sigh of relief? Probably not!
All indications are of weakening corporate credit quality as sales deteriorate, interest rate burdens grow, all built on an increasingly fragile consumer.
The Consumer:
First, ultimately, corporate strength relies on the strength of the consumer, which has proven very resilient supported by a strong jobs market. This resilience, however, could be near its breaking point. The excess cash built up during the pandemic is dwindling. Over the past two years, consumers have drawn down the more than $2 trillion in extra savings they accumulated during the pandemic in order to keep spending in the face of sky-high inflation. That’s enabled the economy to push ahead even as the Federal Reserve pumped up interest rates at the fastest pace in four decades.
At the same time, while the amount of savings significantly dropped from the pandemic era in support of consumer spending, the use of credit cards is skyrocketing. The Federal Reserve reported that Americans borrowed more than ever on their credit cards in the last quarter with balances surpassing $1 trillion for the first time even as overall household debt loads were largely unchanged. Meanwhile, credit card delinquencies are at an 11-year high, as measured using a four-quarter average. This occurs despite elevated interest rates, suggesting that at least some groups of consumers are on shaky ground.
Also noted, household savings supplemented by pandemic-era government payments seem to be dwindling and inflation is eroding wage gains (with real wages being negative). As backlogs of pent-up demand shrink and the labor market weakens, it seems even more likely that top lines (corporate sales) will remain under stress with a growing number of retailers relying on price increases to offset volume declines.
Bank Lending:
As the consumer seems to be on an increasingly precarious ground, banks are raising their commercial and industrial (C&I) lending standards which points to a deceleration in U.S. banks' intermediation to corporates (facilitating borrowing and lending on a widespread scale), starting in early 2024. While stronger investment grade companies still have favorable market access to liquidity, the non-investment grade companies (those more likely to default) become increasingly dependent on the banking system as credit ratings weaken. History suggests that recessions associated with banking strains are both deeper and more protracted, and a sharper downturn is possible if bank lending standards continue to tighten.
In the second quarter, U.S. banks' underwriting standards tightened across all commercial and consumer loan segments, most prominently in C&I and CRE (commercial real estate) portfolios. About half of C&I lenders reported tightening underwriting standards, as did an even larger majority of CRE lenders. About one-third of credit card lenders report tightening underwriting standards for cards, the most for the three consumer asset classes.
A significant portion of bank lenders also reported that underwriting standards in 2Q23 (2nd quarter of 2023) were on the tighter end of the range of underwriting standards from 2005 to today for all major loan categories, most notably for all three CRE loan types. This comes as interest rates rise, and the weaker companies’ interest burden rises as well.
Interest Burden:
The impact of higher interest rates is starting to be felt in cash interest payments, which are increasing rapidly. In combination to ebbing demand, this implies pressure on free operating cash flow and measures of interest coverage may be more revealing of credit risk than leverage measures. All-in borrowing costs are far higher than they were this time last year, attributable to the Federal Reserve’s aggressive rate hikes. Financing conditions look set to remain challenging through the end of the year, especially for the lowest-rated borrowers, with benchmark interest rates unlikely to fall any time soon and lenders becoming more selective. Lower-rated borrowers are vulnerable to liquidity constraints, with earnings under pressure in many corporate sectors and the debt-maturity wall creeping into view. A protracted period of more costly credit would weigh on entities’ debt-service burdens and limit access to funding. The corporate interest rate burden is growing rapidly, and especially burdensome for high yield companies with a large percentage of debt being variable rate. Based on the latest available data, cash interest payments continue to surge, up 17% annually and up 15% from the first quarter.
Source: Moody’s
This is already having a negative impact on corporate profits:
Past performance is not indicative of future results.
Cash Flows:
Based on data through early August 2023, quarterly EBITDA (earnings before interest, taxes, depreciation, and amortization) year-over-year growth has fallen sharply declining 9%. Measured at an annual rate, EBITDA growth now stands at zero compared with 4% in Q1. Rising interest costs and declining EBITDA mean interest cover ratios continue to weaken.
The Debt Maturity Wall
The debt maturity wall approaches rapidly. U.S. corporates have $196 billion in rated debt (including bonds, notes, loans, and revolving credit facilities) due in the second half of this year, followed by $327 billion maturing in the first half of 2024. Nearly 77% of this debt maturing in the next 12 months is investment-grade. Speculative-grade maturities are relatively low in the next 12 months, yet they escalate quickly, rising to $84 billion in the first half of 2024, and to $173 billion in the first half of 2025.
This is especially concerning for speculative-grade companies (those most likely to default) with a high proportion of variable rate debt in their debt structure. Regardless of the maturity wall, these companies still must make interest payments even before debt maturities, payments of which are becoming increasingly burdensome.
It is also noted that the weakest credits — those rated B3/B- or lower — have a rapidly escalating maturity schedule while interest coverage deteriorates:
Recession?
As consensus builds toward a soft landing and away from a recession due to strength in retail sales and labor, there appears to be many signs that a recession could be on the horizon. The rise in mortgage rates, the price of car loans falling, tax receipts, leading economic indicators (LEI) near Covid 2020 lows all point to recessionary pressures. There remains pressure on the banking sector, oil prices are rising, and there is still a high probability that interest rates will be raised again, further pressuring corporate earnings and the consumer, while tight lending standards put pressure on the weaker companies, all placing additional pressure on the economy.
Historically, a recession leads to a higher number of defaults, which we are already witnessing. Through 2Q23, U.S. corporate family defaults continued to grow, increasing around 30% from the end of March with loans defaulting more frequently than bonds. The total amount of defaulted loans stood at $18.9 billion versus $10.4 billion in bonds.
Conclusion:
Given the increasing fragility of the consumer as credit card debt grows on top of higher interest rates, and corporate credit strength already weakening as interest rates rise and cash flows weaken, there appears to be accelerating pressures for a worsening default rate that could very well be higher than that of consensus.
Related: The U.S. Treasury Yield Curve Has Begun to Steepen. Good News? Likely Not.