It’s a question regularly asked but rarely answered with confidence: is the private debt market about to experience another wave of distressed activity? For those who make a living from untying knotted balance sheets, there have been rather too many false dawns in recent times. Even a global pandemic couldn’t offer significant dealflow for more than a few months.
If the latest study from Kroll Bond Rating Agency is anything to go by, the heady mix of economic headwinds we’re currently witnessing may also end in anti-climax for the wave watchers. It hints, in fact, that the “wave” (more of a ripple perhaps) has already been and gone. Those who didn’t hedge themselves against interest rate rises have already suffered their fates and “the damage is mostly done”.
The study, which was published on 15 June, covered 2,000 US mid-market companies and concluded that around 16 percent of them would be unable to meet interest payments from current cash flows if the reference rate rises to 5.5 percent. Just prior to the study, the Fed put rises on hold at 5 to 5.25 percent – close to, but not quite reaching, the level at which KBRA predicts further problems.
This looks far from comfortable, especially given the widely held view that the Fed may resume rises in the face of stickier than expected inflation.
In an assessment of the credit markets published this week, distressed specialist Oaktree Capital Management said there “could be a sustained rise in distressed opportunities”. It highlights the lack of interest rate hedging given that “almost no companies anticipated that interest rates would jump by 500 bps in one year”. Businesses will therefore continue to be squeezed by higher borrowing costs and ultimately unsustainable debt burdens.
While acknowledging that there has not been – and is unlikely to be – a huge increase in the default rate, Oaktree also makes clear there is no room for complacency on this. It points out that the amount of lower-rated corporate debt outstanding has quadrupled since 2007 to over $12 trillion globally, “so even a modest increase in the default rate could create an expansive set of investment opportunities”.
It’s not that companies have no weapons at their disposal, however. KBRA predicts we’ll see a lot of payment-in-kind toggles and loan extensions, and greater interest in convertible debt – all of which represent ways to reduce the interest burden on companies, pushing refinancings further out.
In the meantime, eyes will continue to scan the horizon, searching for that cresting swell.
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