In my Chart of the Week (COTW) from last October, I discussed some of the effects of the higher rate environment on high-yield companies — notably, the effect of larger interest burdens for those companies with heavy exposure to floating-rate debt. It has become apparent with the recent wave of bankruptcy filings that companies are feeling the heat. Play time is over.
According to a May 15 article from Bloomberg, “At least seven large companies filed for Chapter 11 bankruptcy protection in less than 48 hours…That’s the largest number of filings on record during a two-day period since at least 2008.”1 In some instances, companies have filed for bankruptcy for the second or even third time: the dreaded so-called “Chapter 22” and “Chapter 33” filings. Furthermore, a number of companies with similar credit ratings face looming maturity walls that they’ve yet to extend.
As I wrote earlier, companies that didn’t take advantage of the opportunity to refinance (“refi”) prior to the hiking cycle have had a difficult time securing financing. On the other hand, those companies that were able to access the new-issue market have done so with materially higher coupons and, in some cases, shorter maturities as they hope rates will fall over the medium term and allow them to refi again at lower rates.
Some companies have kicked the can down the road, delaying the inevitable, while others have opted for higher, fixed-rate secured debt in lieu of issuing incremental floating-rate debt. “Firms across every sector are struggling with higher interest costs — making it more challenging to refinance loans and bonds,” noted the Bloomberg article.
Across the high-yield landscape, the earnings picture has become less rosy. Amid a difficult operating environment, earnings have come under pressure and liquidity has deteriorated. As I wrote in October, some companies will be unable to service their debt and those with vast amounts of floating-rate exposure may be in trouble.
Ironically, we still see some companies paying a dividend or buying back stock while they face the prospect of being unable to extend upcoming maturities. During the pandemic, companies loaded up on cheap debt while at peak earnings. Their capital structures became bloated, earnings have rolled off record highs and near-term maturities continue to creep closer.
At the same time, May has been the most active month since January for high yield new issues. Furthermore, spreads also seem tight compared to past economic downturns.2 It may be that the lack of new-issue supply has held spreads down. If more and more companies come to market, spreads could widen as bonds continue to price at higher yields. This week’s chart highlights the average option-adjusted spread (OAS) for the Bloomberg US Corporate High Yield Index, still at relatively low levels compared to spreads seen around the time of the Tech Bubble and Great Financial Crisis (both highlighted). This gives an indication of the overall credit quality of the high-yield market. To note, spreads will tend to increase during times of weaker macroeconomic conditions.
In some industries, we have seen earnings quality weaken through the second half of 2022 and into the first half of this year. The earnings strength many companies experienced following the pandemic has largely passed. Now, those companies that prudently managed their capital structures and have been able to keep margins flat are better positioned for a potential downturn.
I mentioned in my October article that fundamental research is necessary to navigate turbulent times like those we’re currently experiencing. That rule still applies. I continue to search for opportunities in high yield with a good balance of risk and reward.
Many companies loaded up on cheap debt and did so at a time when rates were low and earnings had largely begun to peak or already peaked. The exception would be those companies that did so from a point of balance-sheet management, such as to retire higher-rate debt and manage debt-service requirements. Those with top-heavy capital structures face the dilemma of higher interest requirements and lower levels of earnings.
The recent wave of bankruptcies and the higher forecasted default rate is evidence that the interest rate environment we find ourselves in today is beginning to break those capital structures underwritten off peak earnings. With floating-rate benchmarks north of 5%, the effective coupons on certain high yield bank debt have approached 10%.3 Many companies will not be able to play in this normalized rate environment. The recess period afforded to many companies during the era of ultra-low interest rate policy is over and now the hard work is only just beginning.
1Bloomberg – Credit Crunch Fuels 48-Hour Bankruptcy Rush With Seven Filings; 5/15/2023
2Bloomberg – Junk Bond Sales Draw Demand as Strategists Warn About Spreads; 5/22/2023
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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