In my last Chart of the Week (COTW), Interest(ing) Income, we explored the positive side of higher interest rates for corporations that were flush with high cash levels on their balance sheets. With higher interest rates came higher levels of interest income and an additional source of funds (the rich really do get richer in a higher-rate environment).
The flip side of this equation — for heavy users of debt (the U.S. government included, but that is a separate topic), it is getting very expensive. The cost of borrowing and refinancing debt is now skyrocketing, as exhibited by the recent surge in coupon rates for newly issued corporate bonds.
Companies with debt coming due in the near term will now have to pay significantly more to refinance debt maturities. Over the past few decades, refinancing debt was not much of a concern as lower and lower interest rates resulted in a seemingly endless supply of ever-cheapening money.
This created some bad behavior and lax attitudes, where taking on more and more debt was not punished but ultimately encouraged. Many corporations obliged the markets, taking on debt to make splashy acquisitions and prioritize stock repurchases over a conservative balance sheet.
But today, for the first time in nearly 40 years, this refinancing benefit has ended. The math has dramatically changed, with the cost of refinancing debt now resulting in coupon rates for new issues that are 50% to 100% higher for some companies. As a result, interest expense moving forward will jump higher and interest coverage (operating income divided by interest expense) will plummet. Below is a recent example demonstrating this new financial reality:
- Hanesbrands Inc. recently refinanced its maturing debt to extend its debt maturity. Since the company did not have enough cash on hand to pay off this debt, it needed to issue new debt to satisfy its repayment. As this week’s chart shows, the old bond had a coupon rate of 4.63% and the company had $157 million in annual interest expense. After the refinancing, the newly issued bond required a coupon rate of 9% (a 95% increase), which increased the company’s annual interest expense to an estimated $287 million (83% increase).1
As Scott Ellis mentioned in last week’s COTW, the technical strength in the high-yield bond market has been incredible, providing support for credit spreads and lower-rated companies. Simply put, there is way more cash chasing the current supply of corporate bonds available. But in these types of technically strong situations, it is still important to focus on the underlying fundamentals. The fundamental picture, while seemingly stable so far on the earnings side of the equation, has changed significantly on the interest-expense side of the equation — and we would be wise to acknowledge this changing math.
So much of investing requires an assessment or estimation of the unknown. However, solid analysis should start by answering all of the knowns first. In this way, we can be more accurate and realistic regarding any judgments we need to make as investors.
For example, gauging a company’s profitability from year to year can be pretty tricky. So many factors play a role in a company’s success and certain environments can make this work even more challenging. But being open-minded and recognizing all of the apparent risks can help avoid risk while adding value for shareholders. Being aware of industry cycles and other macro factors can help bottom-up security selection, and this higher-interest-rate situation is just one clear example.
The impact of higher interest rates is not intangible. It is a real cost that will create a widening gap — between companies with really good balance sheets and capital allocation strategies, and those that have survived merely because of ever-cheapening debt.
1Stifel – Estimate Update for Extended Hanesbrands Debt Maturities; 3/14/2023
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