Corporate debt: high rates put alarming pressure on coverage

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For a decade, US high-risk borrowers insisted no one should worry about leverage, just pay attention to coverage. Low interest rates implied that for any given dollar of debt, periodic servicing costs would be manageable, allowing for incrementally higher leverage.

Rapid and aggressive monetary tightening has flipped that relationship on its head. 

Many companies gorged on leveraged loans. These often required floating rate exposure to Libor or SOFR benchmarks. Base rates have accelerated from almost 0 per cent to 5 per cent in a year. The businesses are now grappling with liquidity challenges.

The lesson for investors is that there is no single measure that guarantees a company’s sturdiness. Managers themselves must be equally vigilant when designing capital structures.

Cash flow statements could be in far worse shape than they are. Companies in the LSTA Leveraged Loan index report earnings publicly. Their average ebitda has risen since 2011, save for a couple of quarters during the pandemic.

Year-on-year profit growth for the index had often averaged double digits. Ominously, it was down to just 1.8 per cent in the third quarter.

The average coverage ratio of ebitda to interest expense fell to just 4.3 times from a peak of 6 times just four quarters ago, according to data collected by Leveraged Commentary & Data. Including capital expenditure obligations in the calculation forces the coverage ratio down below 3 times. 

LCD points out that while average aggregate leverage has largely stayed constant at around 5.5 times debt to ebitda, the cohort of companies where coverage ratios are reaching stressed levels is ballooning. 

The 2010s saw an explosion in floating rate-leveraged loans, driven in part by demand from the securitisations badged as “collateralised loan obligations.”

The $1tn asset class dominates many private equity-backed capital structures. It is now struggling with the challenge of higher rates. A true downturn — if it materialises — would be a far sterner test.

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