Fed Rate Hikes Pose Risks for Parts of the Junk Bond Market

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This week’s Federal Open Market Committee (FOMC) meeting is largely expected to generate the first formal interest rate hike of 2017. While most market participants are expecting a hike, there are still some who believe Janet Yellen and her team of Federal Reserve presidents will manage to delay hiking rates. There also might be some pockets of the market that get treated worse than others if a rate hike is announced.

According to Fitch Ratings, rising interest rates in 2017 and 2018 are not expected to present a broad concern for U.S. corporate bond issuers in aggregate. Still, pockets of risk could challenge entities at the lower end of the rating spectrum.

LIBOR levels are said to be at or above most pricing floors, with three-month LIBOR at 1.11% as of March 8. Fitch’s warning here is that some of the leverage loan issuers with low credit ratings may be unable to reset the rates under arrangement. Subsequent rate hikes, according to Fitch, would expose leveraged loan issuers to reset risk that could pressure their credit profiles and that might pressure their cash flow generation. Fitch’s report said:

This risk is most acute for deeply speculative-grade credits with large amounts of floating rate debt, already large interest burdens, and limited to negative free cash flow.

Near-term interest rate risk is most evident for leveraged issuers who took advantage of longstanding favorable market conditions to issue large amounts of floating-rate debt, but whose credit profiles deteriorated due to secular challenges or idiosyncratic issues that resulted in higher leverage, depressed cash flows and limited liquidity.

One area that was singled out was in the retail sector. Fitch noted that retail companies with high floating-rate debt exposure (LIBOR or Treasury) could be particularly exposed to interest rate risk if secular challenges offset the benefits of an accelerating economy on top-line growth.

The good news here is that Fitch is less concerned about exposure to fixed-rate high-yield bonds. Fitch showed that high-yield bond spreads do not increase meaningfully until after the Fed has concluded its tightening cycle. Therefore, modest policy rate hikes may not actually bring higher spreads that companies have to pay over their benchmarks. Fitch said:

Interest rates typically rise in response to higher inflation, usually during economic recoveries, implying generally improving credit profiles. Fitch’s Stable Outlook for US Corporates in 2017 supports this view.

Moreover, companies have been proactive in managing maturity profiles. US corporates have aggressively refinanced during nearly a decade of low interest rates, pushing out maturities with long-dated, low-coupon debt to maintain historically strong interest coverage metrics and solid liquidity profiles. We expect fundamentals to remain stable as expectations of growth in cash flow are fueled by persistent cost controls, efficiencies, and revenue growth, albeit weak.

And of course, Fitch has a political risk angle as well. Fitch outlined how fears that interest deductibility may no longer be allowed:

The Trump administration’s tax proposal to cut the corporate tax rate to 15% and eliminate the tax-deductibility of interest expenses adds another layer of risk. Negative cash flow impact from the removal of interest expense deductibility may outweigh the positive cash flow impact from the corporate tax cut for issuers with high debt burdens and debt costs. A Fitch study, set to be released next week, examines this potential negative impact.

All in all, most high-yield bond investors may not have much to worry about when the inevitable interest rate hikes arrive. That being said, companies with floating rates and that may be more credit sensitive could be facing some turbulence ahead.