U.S. interest rates seem poised to remain higher for longer, as Morgan Stanley economists now expect another rate hike of 0.25% at the Federal Reserve’s July meeting. With an extended period of muted economic growth likely to follow, the interest-rate environment has implications for companies’ ability to raise new capital or refinance existing debt.
At present, U.S. companies are staring down a “refinancing wall,” with $2.6 trillion in corporate debt coming due between 2023 and 2025. As companies seek to refinance this debt, higher rates will translate into higher cost of debt for companies, which in turn will weigh on their credit fundamentals. However, companies’ ability to scale the refinancing wall and adapt to a higher cost of debt will vary widely depending on their credit quality. Higher-quality borrowers will be better able to cope, while lower-quality borrowers will find the erosion of debt affordability increasingly challenging and disruptive. As a result, we expect to see decompression in corporate credit markets—that is, lower-quality credit spreads will widen relative to higher-quality credits. Investors should understand which borrowers are most likely to be affected and why bond quality is key, as Morgan Stanley Research anticipates stronger performance for investment-grade credit over leveraged credit in bonds and loans.
Unequal Exposure to a Coming Credit Squeeze
Companies raised a significant amount of capital from mid-2020 until early in 2022. As a result, and with rates staying low until the first half of 2022, most companies have until now been able to remain on the sidelines, insulated from credit-related stress even as interest rates have risen dramatically over the last 15 months. However, as refinancing needs loom larger and higher debt costs persist, this luxury will not last unless the outlook for corporate earnings improves dramatically—which is unlikely.
What’s more, companies’ ability to pay the interest on their leveraged loans has been deteriorating in line with rising rates, which makes loans the most vulnerable part of the corporate credit spectrum. Interest expenses were already rising faster than EBITDA (earnings before interest, taxes, depreciation and amortization) for the median loan borrower in the fourth quarter of 2022 and have accelerated since, meaning that interest coverage ratios (ICRs) are declining.
By the end of 2023, assuming that earnings growth remains flat, ICRs on loans will likely trend below historical averages, dropping to 4.5 from a peak of 5.5 in the fourth quarter of 2021. If earnings growth declines, ICRs could dip close to recessionary troughs and significantly increase the number of companies with stressed ICRs. And this analysis covers only existing debt: If we include the approaching wall of maturities in this calculation, ICRs will come under even greater pressure. Unsurprisingly in this environment, we expect loan-only structures to underperform mixed-capital structures.
For larger and higher-quality borrowers, the outlook is meaningfully different. While investment-grade companies will see their coverage ratios decline from their current levels of robust health, they should weather the challenges through gradual ICR declines and a voluntary focus on right-sizing balance sheets.
Our expectations for spreads and returns reflect these differences based on credit quality. For investment-grade credit, Morgan Stanley Research forecasts positive excess returns (0.5%) and more robust total returns (7% to 8%). For high-yield bonds and loans, we expect negative excess returns and total returns in the 4% to 5% range, or less in the event of volatility and downside risks.