Absorbing the impact of higher rates
Driven by the rise in interest rates over 2022-2023, the leveraged loan market’s average coupon, which is priced at a floating rate, increased by 527 basis points (bp), compared to just 43bp on the average fixed rate coupon of HY bonds. High yield bond issuers therefore have more time to adjust to today’s higher rate environment, with many of these companies putting in place very low coupon debt at eight-to-10- year maturities over the past few years when rates were low. This means that HY company balance sheets generally remain resilient while both leverage and interest coverage ratios remain healthy, despite a pick-up in dispersion.
Meanwhile, there is less pressure today on the overall HY market from the immediate impact of higher rates being felt by loans because the surge in loan-only borrowers has decreased the number of HY capital structures with a combined bond and loan/floating rate exposure. This is an area that will need to be closely monitored among combined HY bond and loan issuers for any downward pressure that the additional expense incurred by the loan component may put on the whole capital structure.
So, has the impact on the US HY market merely been postponed, not avoided, until bonds are refinanced or mature? The evidence so far suggests the HY bond market is adapting well, underpinned by the common shared goal that company management teams now have with bondholders in keeping overall leverage low, so that overall interest expense is not so much higher today than when rates were low. This is leading to idiosyncratic credit improvements across the HY rating spectrum.
However, a small percentage of the HY market consists of companies entering this period with negative operating trends and more leverage, finding themselves unable to adjust their capital structure or raise new capital to cope with higher rates. Here, problems are emerging – leading to liability management exercises and distressed exchanges, when companies restructure their debts to avoid default.