Rising Rates Magnify Downside Risk for Leveraged US Corporates, Says Fitch

US corporate credit profiles are broadly insulated from rising interest rates, although lower rated issuers battling secular decline or facing idiosyncratic issues are more vulnerable, according to Fitch Ratings.

Fitch finds that even under a severe stress scenario (500-basis-point [bp] shift in LIBOR with static EBITDA), its overall speculative-grade portfolio maintains median interest coverage of almost 3.0x. As a result, Fitch does not see significant interest rate risk existing broadly across speculative-grade credit profiles.

“Still, a rising rate environment may limit the flexibility and margin of error available to an issuer that is digesting a material acquisition or adjusting its business model to combat secular and cyclical issues,” says the ratings agency.

“This holds especially true for highly levered issuers. Our ratings may reflect some level of success in executing key initiatives, synergies and cost-saving programs. However, poor execution, coupled with rising rates, may compound an already-weak cash flow profile, leading to potential negative rating actions.”

Exposed to interest rate risk

Sectors with high floating-rate debt exposure, like retail, could be particularly exposed to interest rate risk if secular challenges offset the benefits an accelerating economy could have on top-line growth.

Other sectors with high floating-rate exposure like diversified manufacturing could also see improved end-market demand. However, external factors like increased trade restrictions from the Trump administration could limit growth and pressure costs.

Conversely, sectors with low floating-rate exposure like telecom have their own set of challenges as high penetration rates and mature businesses combine with a grinding competitive environment to mute growth prospects.

Assuming static EBITDA levels and no interest rate hedging, an analysis across our portfolio finds that EBITDA coverage for a sector with high exposure to floating-rate debt, such as diversified manufacturing, declines by a full turn after a 200-bp increase in LIBOR.

In comparison, EBITDA coverage for a sector with low floating-rate debt exposure, such as Telecom, declines by roughly one-half a turn after a 200-bp LIBOR increase.

Unlike floating-rate debt, exposure to fixed-rate high-yield bonds is less of a concern to credit profiles in the near term as only 15% of high-yield bonds outstanding are due in the next three years.

Additionally, if history is a guide, high-yield spreads do not increase meaningfully until after the Fed has concluded its tightening cycle. Rates typically rise in response to rising inflation, usually during economic recoveries, implying generally improving credit profiles.

Fitch’s stable outlook for US corporates in 2017 supports this view. As a result, modest rate increases without corresponding increases in spreads would not have a meaningful impact on interest expense in the near term as companies have been proactive in managing maturity profiles.

Investment-grade (IG) corporates are less vulnerable to rising rates as a result of very healthy interest coverage metrics (9.3x), good cash generation and a predominantly fixed-rate capital structure.

“We estimate our portfolio of speculative-grade corporates to have 52% of floating-rate debt on average compared to only 15% for IG,” says the ratings agency.

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