The Federal Reserve has been increasing interest rates to combat inflation, which is likely to result in more corporate defaults in the coming months. In May, the corporate default rate rose, indicating that US companies are struggling with higher interest rates that make it more expensive to refinance debt, as well as the uncertain economic outlook. Moody’s Investors Service reports that there have been 41 defaults in the US and one in Canada so far this year, which is the most in any region globally and more than double the same period in 2022.
High Interest Rates as the Biggest Culprit of Distress
According to bankers and analysts, high interest rates are the biggest culprit of distress. Companies that require more liquidity or those with hefty debt loads in need of refinancing are faced with a high cost of new debt. The options often include distressed exchanges, where a company swaps its debt for another form of debt or repurchases the debt. Or, in dire circumstances, a restructuring may take place in or out of court. The cost of capital has increased significantly, as the cost of debt financing has gone up from 4% to 6% on average over the last 15 years to 9% to 13% now. As a result, restructuring and advisory firms such as M3 Partners have been particularly busy across numerous industries since the fourth quarter.
Expected Increase in Default Rates and Possible Bankruptcies
Moody’s predicts that the global default rate will rise to 4.6% by the end of the year, higher than the long-term average of 4.1%. The default rate is projected to increase to 5% by April 2024 before beginning to ease. Envision Healthcare, a provider of emergency medical services, was the largest default in May, with over $7 billion in debt when it filed for bankruptcy. Other companies, such as Monitronics International, Silicon Valley Bank, Bed Bath & Beyond, and Diamond Sports, have also filed for bankruptcy this year. While some defaults are due to industry-specific reasons, such as Envision’s healthcare issues arising from the pandemic, Bed Bath & Beyond’s large store footprint while customers opted for online shopping, and Diamond Sports’ decline due to consumers dropping cable TV packages, many defaults are due to high interest rates and economic uncertainty.
According to Tero Jänne, co-head of capital transformation and debt advisory at investment bank Solomon Partners, the default rate is a lagging indicator of distress, and defaults often don’t occur until well after several initiatives to address the balance sheet. Mark Hootnick, also co-head of capital transformation and debt advisory at Solomon Partners, expects more defaults, as many companies that shouldn’t be tapping the debt markets have been doing so without limitations due to the lax credit environment. The default rate depends on leverage and liquidity, and cyclical sectors such as durable consumers goods will be affected if people cut back on spending.
The rising interest rates and economic uncertainty have contributed to the increase in corporate default rates. The cost of capital has increased significantly, making it more expensive for companies to refinance debt or acquire new debt. As a result, many companies have filed for bankruptcy, and more defaults are expected in the coming months. The default rate is a lagging indicator of distress, and companies with more financial stability may also face issues refinancing due to high interest rates.
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