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Before a company reaches a distressed state, it typically experiences credit stress. This is the stage where a company can still manage its debt, but if it were to refinance at current US interest rates and spreads, it would have to pay coupons of at least 10%. Bank of America defines a bond or loan as being in “distress” when its yield trades at least 10 percentage points above its risk-free benchmark. However, due to the Federal Reserve funds rate being above 5%, the bank’s strategists decided to analyze a wider range of debt for potential problems. They expanded their analysis to include debt that is in what they call “pre-distress” or stress. According to the strategists, around $550 billion of the approximately $1 trillion in new corporate debt from the past five years is either in stress or distress. Half of this money is in well-performing capital structures, while the other half is in various stages of stress. We are monitoring $400 billion in bonds and loans that are trading at least 600 basis points above their risk-free benchmark, which we consider “pre-distress”. If these were to be reset at current levels, their coupons could be 10% or higher. Additionally, there are $150 billion in deeply distressed assets (bonds trading below 60 points and loans trading below 75 points), where refinancing is no longer an option at current levels, unless there is a restructuring or improvement in prices.
What is interesting is that despite the high-yield bond market’s yield trading at relatively narrow spreads over Treasuries, historically speaking, there is still cause for concern. Companies that issue fixed-rate bonds have time before their borrowing costs increase, as they don’t have to refinance until the bonds mature. However, loans and private credit usually have floating interest rates, which reset to current benchmark rates more than once a year. In their survey, the bank includes syndicated loans, private debt, and high-yield bonds. Some argue that floating-rate issuers can hedge their exposure to rising rates by using swaps to lock in a fixed rate. However, according to Bank of America’s strategists, only 24% of floating debt was hedged by swaps going into this period of higher rates. It is worth noting that the timing of these hedges is important. If a company sold a floating-rate loan with interest rate hedges in August of last year, they could be in a better position since rates are still significantly higher than they were then. However, so far this year, these hedges may not be as helpful, as short-term rates are at their highest levels since 2007.
The strategists at Bank of America modeled increases in interest costs in different scenarios based on CPI, which likely refers to different Federal Reserve policy-rate regimes and/or long-end yields. They found that credit markets may already be factoring in the anticipated stress in the healthcare, telecoms, and technology sectors due to higher rates. However, investors may be too optimistic about the services sector, as the ranking shows health and tech among the top five most stressed segments, with retail and finance not far behind. Surprisingly, services are lower on the list, which presents an opportunity for potential wider repricing.
On the other hand, sectors such as cable, telecoms, media, and chemicals are among the most stressed sectors, even though they are not the most vulnerable to the argument of capital deprivation that we are developing here. We find these three situations to be more interesting as a result. The risk of “capital deprivation” may be a more fitting term than “pre-distress” or simply “stress”. Either way, junk-rated companies will be affected by the higher cost of borrowing.
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