The ability of big U.S. companies to pay interest on their debt could sink to the lowest level in two decades, if the Federal Reserve opts to keep interest rates higher for longer, according to BofA Global.
Major corporations, like homeowners, embarked on a borrowing blitz during the pandemic when the Fed cut its policy rate to almost zero in a bid to thwart an economic calamity from unfolding.
That helped insulated many large corporations and households from the brunt of the Fed’s rate hikes since March 2022, mainly because it put a fixed, lower cost on their existing debt.
But if the central bank keeps its policy rate high for years to come as part of its inflation fight, it risks sinking the ability of many corporations to pay interest on their debts to some of the lowest levels since 2003 (see chart), according to BofA Global strategists.
Interest coverage could sink to some of the lowest levels since 2003 if the Fed keeps rates high over the next two years.
BofA Global Research, ICE Data
Specifically, the BofA team looked at estimated interest coverage ratios for corporations with investment-grade credit ratings should the Fed keep its policy rate elevated through the end of 2025.
Higher coverage ratios imply companies will have an easier time paying interest on their outstanding debt.
The analysis assumes rolling maturing debt at the current 5.5% yields of the ICE US Corporate Index, which would bring the coverage ratio to 8.7x by the end of 2025, down from 11.9x as of the first quarter of this year. It also assumes no change in debt or earnings.
“Of course, the impact on the coverage ratio will depend on how long rates remain high,” the BofA team led by Yuri Seliger wrote, in a Tuesday client note.
It’s also worth noting that debt defaults by investment-grade companies have been fairly rare, although getting their credit-rating downgraded to speculative, or “junk,” territory hasn’t been uncommon.
See: Ford moves closer to investment grade after Moody’s upgrade, as its bonds see net buying
The Fed is widely expected to raise interest rates another 25 basis points to a range of 5.25%-5.5% on Wednesday.
The 10-year Treasury yield
TMUBMUSD10Y,
a benchmark for corporate borrowing, was at 3.89% on Wednesday, down from a high of nearly 4.1% in March, according to Dow Jones Market Data.
Stocks were mostly lower ahead of the Fed’s rate decision, with the Dow Jones Industrial Average
DJIA,
struggling to extend its win streak to a 13th straight day and the S&P 500 index
SPX,
and Nasdaq Composite Index
COMP,
trading lower.
Individuals often gain exposure to corporate bonds through bond funds and exchange-traded funds. The iShares iBoxx $ Investment Grade Corporate Bond ETF
LQD,
the biggest investment-grade corporate bond ETF, was up 2.2% on the year through Wednesday, according to FactSet.