Beneath the Tide of Rising Earnings
With the Federal Reserve (Fed) now targeting 2.00–2.25 percent on fed funds, tightening monetary policy is putting increasing pressure on corporate borrowers’ balance sheets across the leveraged credit landscape. We estimate that about 30–50 percent of the increase in short-term borrowing costs to date has passed through to the cost of debt for leveraged credit, depending on sector, and we expect this passthrough to increase over the next 12 months as the Fed raises rates.
Strong earnings growth is masking this rise in borrowing costs, as interest coverage has improved over the past eight quarters. However, factors that have contributed to strong earnings growth—a favorable base effect from weakness in 2016 and 2017, and fiscal stimulus from tax cuts and government spending—will fade in 2019 and turn into headwinds by 2020. At the same time, the factors compelling the Fed to raise rates are only growing stronger, which will lead to even higher cost of debt. Given existing drivers, the balance of risk is to the downside for credit.
- According to our tracked universe of just over 600 issuers, median year-over-year growth in earnings before interest, tax, depreciation, and amortization (EBITDA) was 12 percent in the second quarter of 2018, the highest since 2011.
- Strong earnings growth is masking the rising cost of debt. With earnings expected to peak this year while the Fed forges ahead into restrictive territory, we expect that now is as good as it gets for interest coverage.
- The share of leveraged credit issuers that recorded trailing 12-month losses in the second quarter of 2018—so-called “zombie” companies—is at a decade low. In our universe of issuers, only six had negative 12-month trailing EBITDA.
- We estimate that roughly 30–50 percent of the rise in short-term interest rates has passed through to loan issuer cost of debt, and we expect this passthrough to increase in the next 12 months.
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