Business is slowing and interest rates have jumped for junk-rated US companies. Investors who trade their loans, along with corporate chiefs, remain undaunted.
Optimism has burgeoned that highly indebted businesses from consumer manufacturers to software firms will get through the coming quarters relatively unscathed. Loan prices have rallied, defaults remain low and executives say that higher borrowing expenses and weakening demand aren’t significantly altering their plans.
Their confidence has buttressed the $1.5 trillion market for loans to companies rated below investment grade. The loan market helps keep cash-poor businesses afloat and provides much of the funding for Wall Street’s mergers-and-acquisitions machine.
It also offers investors higher returns in exchange for taking additional risk. Unlike junk-rated bonds, so-called leveraged loans typically carry floating interest rates, so payouts to investors—and costs for borrowers—have risen with the Federal Reserve’s aggressive rate increases.
Some investors have worried that the added pressure on already shaky balance sheets could spark a wave of missed payments or bankruptcies. That could also presage bigger problems in the economy. Loans were initially resilient last year as the Fed started bringing rates higher, but returned roughly minus 4.5% in a 10-week stretch through May and June as concerns about slowing growth set in.
Now prices have rebounded and borrowers are finding lenders. Executives at many junk-rated companies say they don’t foresee challenges to paying their debt on time.
Sales surged at Chamberlain Group during the pandemic, when stuck-at-home consumers spent more on the company’s LiftMaster garage-door openers. Its growth attracted private-equity giant Blackstone Inc., which bought Chamberlain in November 2021, valuing the company at about $5 billion including debt.
Since last summer, rising interest rates have cooled the housing market and inflation has sapped household budgets, pulling Chamberlain’s sales behind its managers’ projections in the second half of last year. Meanwhile, the all-in rate that Chamberlain pays on the roughly $2 billion floating-rate loan that financed Blackstone’s acquisition has increased to more than 6.9% from roughly 4.9% when it was issued. In October, Fitch Ratings downgraded the rating on the loan to B from B-plus, citing higher debt levels and lower profit margins.
Still, the burden hasn’t disrupted Chamberlain’s plans to invest in product development, said Brendan Gilboy, its finance chief. “We’re feeling that pressure, but it’s not affecting our strategy at this point,” he said. He projected that brand strength would bolster sales through a downturn, leaving debt payments unstressed.
Investors’ outlook for the market also remains upbeat. Morningstar’s index of market-traded corporate loans with below-investment-grade ratings hasn’t fallen on any trading day since Dec. 20, about eight weeks ago. It has gained 3.5% so far this year, erasing 2022’s losses.
When rates rise, loans reward investors with greater income. But higher interest expenses risk stretching a borrower too thin, potentially tipping the company into default.
Reflecting that increase, the yield offered by Morningstar’s index of the 100 most traded loans stands around 8.9%, up from 4% a year ago.
Some businesses, including Chamberlain, have used contracts called interest-rate swaps to soften the blow. In these deals, a third-party financial firm takes a borrower off the hook for changes in interest rates, in exchange for fixed payments. Borrowers without swaps remain exposed to higher interest costs, but many project they will still have enough cash to make payments.
Precisely Holdings LLC., a maker of business software, experienced slowing growth in the second half of last year, Chief Executive Josh Rogers said. Project-approval cycles for business customers have slowed, he said, part of the reason that tech companies are broadly bracing for a downturn.
Precisely has tightened its belt, cutting about 5% of its workforce this year and reducing office space. Even though interest payments have grown more expensive on Precisely’s loans, the burden remains manageable, Mr. Rogers said. The company issued roughly $2.1 billion of loans in 2021 and issued add-on debt last year, according to Leveraged Commentary & Data.
One factor supporting Precisely and most other junk-rated borrowers is that few have to worry about seeking new financing for years to come. At issuance, Precisely’s 2021 loans were set to mature in 2028, according to LCD.
Many peers followed a similar strategy. Of the 100 most-traded loans Morningstar tracks, none are due this year and only five mature in 2024. Forty-four are in place until either 2028 or 2029.
Investors are betting that far-off maturities can help keep defaults in check even if a recession hits. By dollar amount, just 0.8% of Morningstar’s loan index was in default last month, according to LCD, a slight rise from December but far below the 10-year average of 1.9%.
Defaults might rise to closer to 3% next year, said Roberta Goss, head of bank loans at Pretium Partners LLC. But the risk is concentrated among a limited group of companies with the worst strategic outlooks, she said.
Some concerns have focused on loans that come directly from debt investors, not Wall Street banks. Investors consider the fast-growing $1.4 trillion private-lending arena more opaque and potentially more risky than public credit markets.
Executives at companies that have borrowed in private markets still remain upbeat about the outlook.
Sales growth declined last year for Woodstream Corp., a Lancaster, Pa.-based maker of pest-control products, as retail chains cut back on orders. Adding to the crunch, the interest rate on the company’s term loan has jumped to about 10%, from about 5.7% last year.
Profit is set to rise nonetheless as price increases on Woodstream’s mousetraps start to make up for the higher supply costs it faced last year, Chief Executive Miguel Nistal said.
“With the cash flow from our business, we can weather higher interest rates,” he said.