Higher Interest Rates, Here Today And Tomorrow

The federal reserve will likely continue to hike rates through early 2023, albeit at a slower pace.  Policy rates increased by more than 400 basis points in the U.S. last year, and we believe additional increases are likely due to persistently elevated inflation and low unemployment. S&P Global economists expect the federal funds policy interest rate will rise to just over 5% by the middle of this year, before the Fed reverses course later this year, leading to rates somewhat declining in 2024. The expectation for lower rates in 2024 and 2025 could present issuers with opportunities to implement longer-dated interest rate hedges on terms more attractive than those currently available.

We estimate a roughly one-in-three chance the fed funds rate could peak at about 6% this year in our downside scenario.   While some recent indications suggest inflationary pressures have started to ease, key economic variables currently indicate more rate hikes will be required this year to tame inflation. In our macro downside scenario, to which we ascribe a one-in-three likelihood, higher interest rates will be required to cool demand and reduce inflation such that the fed funds policy interest rate increases to greater than 6% this year and remains higher than 4% through 2024. This could result in increased liquidity strain and longer-term refinancing difficulties for highly leveraged, unhedged borrowers with tight cash balances also facing macroeconomic headwinds.

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Higher Interest Rates Pose Near-Term Risk To Credit Quality

Issuers rated in the 'B' category are particularly exposed given their large debt overhang.   Following a period of heavy refinancing activity in 2020 and 2021, issuers built up cash balances and extended their debt maturity profiles. In the absence of significant near-term debt maturities and a general weakening of covenants and other credit protective measures, we view an extended period of higher interest rates, together with weakening economic growth and higher input costs due to persistent inflation as key risks to credit quality in the sector.

As the federal reserve aggressively hikes interest rates to curtail inflation, the cost of hedging rising interest rates has correspondingly increased sharply. As a result, only about 50% of business and technology services issuers rated 'B' or 'B-' are currently hedged through interest rate derivative contracts, and these hedges provide protection for an average of only 64% of the total notional value of outstanding debt.

A small number of surveyed issuers who remain unhedged through interest rate derivative contracts are somewhat insulated by natural hedges from interest income, or by their larger proportions of fixed-rate debt issuance. That said, we expect interest expense for unhedged issuers in the 'B' and 'B-' rating categories to increase by over 40% on average this year, from 8% last year. Coupled with recently implemented limitations on the tax deductibility of interest expense, we believe higher debt service costs will challenge cash flow generation and liquidity improvement across the sector this year.

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Companies That Implemented Hedges Are Well Positioned, For Now

Borrowers that entered into hedges are temporarily well protected, but many will likely face higher costs as hedges expire.   On average, across the 93 issuers we reviewed, those that implemented hedges have locked in a base interest rate of 2.5% and most companies that entered into hedges prior to last year have locked in base interest rates below 2%. This provides significant protection relative to peers who remain unhedged. For example, this lower base interest rate would allow hedged companies to maintain steady EBITDA-to-interest credit metrics in 2023, relative to a 0.6x decline year on year for unhedged floating rate borrowers. Our analysis assumes no change in earnings, capital expenditures, or working capital. These assumptions are conservative because we believe companies in the business and technology services sector are generally able to reduce variable costs, pass through price increases to offset inflation to some extent, and would likely benefit from a source of cash from working capital due to declining accounts receivable in an economic downturn.

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Nevertheless, just over half of the derivative contracts implemented by these issuers are set to expire within the next 24 months. If interest rates remain high, these issuers may be unable to renew their protection on favorable economic terms.

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The Outlook Bias Will Likely Become More Negative This Year

Our sector rating outlook bias has recently begun to shift negative indicating a rising risk of downgrades due to higher rates and slowing growth.   The negative outlook bias for business and technology services issuers rose to 16% from 13% since October 2022, reflecting our expectation for greater pressure on margins and cash flows from rising interest rates and slowing growth. 'B' rated companies are better positioned than 'B-' rated companies to withstand a sustained increase in debt service costs given their higher cash balances, lower leverage, more resilient business models, and slightly higher proportion of fixed-rate to floating-rate debt. Issuers facing slowing demand, limited ability to pass through higher costs, and unhedged floating rate debt exposures are concentrated at the 'B-' rating threshold and are more vulnerable to downgrades and negative outlook revisions within the next 12 to 24 months.

Even in cases where liquidity levels are currently sufficient and near-term debt maturities are minimal, persistently higher debt service costs could limit free operating cash flow generation and our longer-term view of capital structure sustainability. Furthermore, to the extent that cash flow pressures drive declines in debt trading prices, we believe issuers with healthy cash balances are generally at greater risk to execute subpar debt exchange transactions that we could view as distressed and tantamount to a default.

Rating Outlook Distribution: U.S. Business And Technology Services

Negative rating outlooks have marginally increased over the past three months. 

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Issuers Rated 'B' Or 'B-' At Risk Of Downgrade Or Outlook Revision

We expect rising interest rates to contribute to weak EBITDA-to-interest coverage and cash flow credit metrics this year, resulting in potential outlook revisions and downgrades.   Our ratings at the 'B' and 'B-' threshold generally place a greater focus on liquidity and capital structure sustainability. Companies at the highest risk for a downgrade are those exposed to rising debt service costs while simultaneously facing slowing demand, supply chain challenges, and higher costs for other inputs that collectively threaten to constrain cash flow and render debt burdens unsustainable.

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