Rising Interest Rates Could Crush Some Small Caps
A recent post on CFO.com summarizes the Institute of International Finance’s (IIF) latest capital markets monitor report.
According to the IIF’s latest capital markets monitor report, “U.S. Corporates’ Net Debt: An Uneven Burden,” in the last 10 years “U.S. corporations have experienced a deterioration in their ability to pay interest on outstanding debt.”
“While leverage has increased across the board (both on a gross and a net basis), small-cap firms in particular have an increasingly serious problem with interest payment capacity — leaving them quite vulnerable to rising interest rates,” according to the IIF paper.
When measuring debt to earnings, what the authors label “gross debt to earnings before interest and tax,” small-cap firms show the largest increase in leverage since 2007, at 3.5x.
Small caps also have the poorest interest coverage ratios (ICR), which reflect “companies’ ability to pay interest on their debt out of current earnings.” The median ICRs (a ratio of EBIT to interest payments) of the small-cap companies in the group fell to what the IIF calls “essentially nil” in 2017, down from 2.7x in 2007. That essentially means, the IIF authors note, that these companies “have to run down their assets or borrow more just to pay interest on outstanding debt.”
Any company with an ICR below 2.0 (which the IIF calls “stressed”) will be “quite vulnerable” to any further increases in interest rates going forward, say the IIF authors. (About 20% of the firms examined fall into the “stressed” category.)
The Federal Reserve’s unwinding of its balance sheet could also pressure these borrowers, especially if they have high-yield debt outstanding, say the authors.
The process of reversing quantitative easing in the United States could raise high-yield spreads by 300 basis points by the end of 2018, which would result in a 0.8 points decline in the median ICR of high-yield borrowers. The IIF calls that a “substantial deterioration that would have negative implications for corporate creditworthiness.”
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