Interest costs have risen sharply with interest rates, sparking speculation about whether companies with loan-only capital structures might be more vulnerable than their peers in the leveraged loan market. Loan-only capital structures have become standard in the leveraged loan market over the past several years, and we have long argued that a company’s enterprise value matters more than the structure of its debt. We believe limiting accusations of deteriorating debt service capacity to companies with loan-only structures is unfair.
Consider the chart below, which compares the weighted average coupon of loan-only, bond-only and mixed capital structures. Since rates started rising in early 2021, companies with floating-rate debt in their structures have seen their weighted average coupon grow faster than those with bond-only or mixed structures, which generally have a smaller percentage of floating-rate debt. This is simple arithmetic reflecting an increase in costs, not a company’s ability to service its debts.
Context is important
Charts only tell part of the story, and it’s important to put them in context. Here are some key points to keep in mind as you think about companies’ debt service capacity and how they structure their debt.
First, as shown in the chart, leveraged loans are often a significantly cheaper funding vehicle for companies than bonds. That’s why companies tend to come to the loan market first, and it’s one of the reasons why loan-only companies have grown so much, in our opinion. Issuers reaped the benefits of lower floating-rate costs for most of the past decade or so.
Second, remember that rising costs are not a measure of a company’s ability to pay its debts. As credit researchers, we do our best to determine what a company’s forward-looking interest coverage might be. That means calculating each company’s expected EBITDA[i] and interest costs over the next 12 months, including whether we expect further interest rate changes, and shocking those estimates. For the 400+ loans we track at Loomis Sayles, interest coverage ranges from 2.81x for loans rated B and below, to over 6x for loans in the BB category.[ii] Those figures are robust in our view, and they don’t include the many other options companies often employ for debt servicing, including cash on hand, revolving credit lines for borrowing purposes, cash infusions from sponsors and interest rate hedges. So while costs have risen, it doesn’t necessarily mean companies can’t pay them.
Finally, the Loomis Sayles Macro Strategies team, along with many others in the market, have begun forecasting interest rate cuts within the coming year. If that happens, we may see the costs for loan-only issuers start to decline just as abruptly as they rose.
Keep calm and dig deeper
Investors who feel spooked by rising costs and sell loan-only companies now may find themselves in the opposite position when rates reverse and costs fall. By then, loan-only structures would likely be priced higher than the market is seeing today. First impressions can be hard to overcome, but portfolio losses can be even harder to accept. Corporate health involves much more than a company’s interest costs, and it’s important to consider the full picture before making decisions.
[i] Earnings before interest, taxes, depreciation and amortization.
[ii] Loomis Sayles estimates.
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