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February 23, 2024

Breakingviews: Higher rates insidiously creep into the boardroom

by Breakingviews.

After heaving a sigh of relief for the end of interest-rate hikes, chief executives and investors should be taking a deep breath. Even if the U.S. Federal Reserve starts reversing its policy later this year as expected and makes money available a little more cheaply, corporate borrowing expenses will nevertheless keep rising. To cover them, companies could be forced to seek cutbacks elsewhere. Stock buybacks, new projects and cash-funded takeovers look especially vulnerable.

The most immediate and dire consequences of 11 rapid-fire increases in the benchmark U.S. federal funds rate have mostly flowed through the financial system. A series of new highs in the S&P 500 Index this year attest to how concerns are waning. The fresh exuberance, however, ignores insidious effects likely to linger for years. As companies steadily refinance their debt, at inevitably higher costs, many of them will be confronted with difficult choices.

For the most part, business balance sheets are in pretty good shape. Many chief financial officers took the opportunity afforded them during the pandemic, and sometimes even earlier, to lock in ultra-low rates and push out the date when their debt comes due. Companies with better credit ratings did so more easily than their weaker peers, but such initiatives were fairly widespread.

Comcast, whose nearly $88 billion of net debt makes it one of the biggest corporate borrowers in the world, is a notable example. President Michael Cavanagh has been touting the U.S. cable operator’s ability to refinance some 40% of its obligations since 2018. He told investors that extending the average maturity by four years to an average of 17 years at a weighted, and largely fixed, cost of about 3.6%, should “asymmetrically advantage” it against telecommunications industry rivals, which include Verizon Communications and AT&T.

For many other issuers, especially those considered to be at the highest risk of default, pressure is building. It’s higher for speculative-grade borrowers, or ones rated BB+ or lower by S&P Global, excluding banks and others in the financial industry. The sum they must repay more than doubles from about $220 billion in 2024 to $460 billion in 2025 and then more than doubles again to $1 trillion by 2028, according to the credit rating agency.

The crunch will show up even sooner than that, however, and probably before central bankers meaningfully cut interest rates. Nearly a third, or about $7.3 trillion, of all nonfinancial corporate debt, including investment-grade, matures over the next three years. And because companies typically refinance debt 12-18 months in advance, a lot of borrowing will take place at a steeper cost. Lower-rated companies are bound to feel the squeeze more acutely.

Safer borrowers also have balance sheet adjustments to make. Excluding the anomalous post-Covid peak, their leverage, without accounting for cash on the books, ended the year at an all-time high, of about 2.3 times trailing 12-month EBITDA, estimates Morgan Stanley strategist Vishwas Patkar. By his calculations, all companies, regardless of credit quality, would have to collectively slash their debt by 24% just to keep interest expenses the same.

This helps explain the mounting concerns in boardrooms. Based on a measure of how frequently companies mention financing-related costs and risk-related terms during their earnings calls, interest expenses were becoming a bigger concern than they have been over the past decade, according to research released in August by economist Falk Bräuning and his colleagues at the Federal Reserve Bank of Boston. Moreover, CEOs are starting to temper expectations. So far this year, their earnings outlooks have fallen short of what analysts were forecasting more than three times as often as exceeding them, data provider LSEG has found.

Ultimately, companies have multiple ways to cope with an extra 3 to 5 percentage points of interest. Layoffs are one, but they may only offset already higher wages. There’s already some evidence that buyers are changing how they fund acquisitions. In early 2022, half of all M&A volume for which the currency used was known – excluding private equity buyouts – was paid for entirely in cash, according to LSEG. The proportion has now dipped to 35%, the lowest level in more than a decade, while the combination of cash and stock represents a record 25% of deal activity. It’s happening in deals of all sizes, too. Software developer Synopsys  is using both to buy Ansys for $35 billion as is sports-betting giant DraftKings with its $750 million purchase of lottery app Jackpocket.

Stock repurchases may also get the chop. With many equity prices high, buying back stock now, even if it artificially flatters earnings per share, might look foolish later, and all the more so if it uses up cash that could instead pay down expensive debt or requires borrowing more at a higher cost. There were about $800 billion of buybacks last year, S&P Global estimates, a 13% dip from the record amount in 2022. The new 1% excise tax on buybacks implemented under U.S. President Joe Biden also makes them less inviting.

Some might even take the more extreme step of cutting, or halting, their dividends, as Swiss commodities trader Glencore, Australian miner BHP and German conglomerate Bayer just did this week. There’s no clear evidence yet that it will become a trend, though. Members of the S&P 500 devoted an estimated record $590 billion to such payouts last year, despite persuasive arguments that they have little benefit and can even be harmful to shareholders. Similarly, capital expenditures in buildings, equipment and the like, which have shown no signs of slowing, may be targeted by some borrowers seeking to manage their cash, particularly if consumers start to pare their own spending.

All this belt-tightening will at least be gradual. The Boston Fed found that it takes five quarters before an initial 1 percentage point increase in the benchmark rate has its peak effect on a company’s interest expense. The U.S. central bank was raising rates as recently as July, so it will take time for all the repercussions to show up on corporate balance sheets. Show up they will, however, leaving unprepared investors catching their breath again.

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