The U.S. Federal Reserve’s steady rise in interest rates has pulled inflation down to 3 percent in June, close to the central bank’s 2-percent target rate—but the economy may pay a price in a rising number of bad corporate loans.
Companies borrowed eagerly to fund their operations when interest rates were near zero and the COVID War was raging. Since 2022, those rates have climbed steadily, leaving businesses that took out variable-rate loans with ever-higher payments to meet.
“As debt comes due and businesses still in need of cash are forced to renew their financing at much higher interest rates, bankruptcies, and defaults could accelerate,” The Wall Street Journal warned.
We predicted a rising tide of distressed corporate debt in “Corporate Bankruptcies to Reach 13-Year High, Data Shows” (23 May 2023) and “$500 Billion in Distressed Corporate Debt Presages Wave of Bankruptcies” (25 Jul 2023), among other articles.
The risk becomes more pronounced if the central bank holds its rates higher for longer. Fed chair Jerome Powell has insisted repeatedly that the Fed will not cut rates this year and markets have gradually come to believe him.
The central bank’s latest projections show interest rates still near 4.6 percent at the end of 2024, 17 months from now. Many analysts think rates will come down to between 3.75 and 4.25 percent by then, distinctly lower than now but still much higher than they were when so many corporations larded up on debt.
The longer interest rates remain at their present height, the more companies are at an increasing risk of being unable to meet their debt payments.
About 37 percent of firms reviewed in a recent Fed study are likely to have difficulty securing new financing when their current loans come due, central bank analysts predicted.
That probably would force those companies to retrench, halting hiring or laying off staff and putting off plans to expand.
That would ripple through the economy “stronger than in most tightening episodes since the late 1970s,” the Fed report said.
Defaults among publicly traded companies already are more numerous than any time in the past 10 years, even outpacing those during the COVID era, S&P Global Ratings noted.
About $858 billion in corporate debt now carries a credit rating of B- or lower, ratings reserved for companies increasingly in danger of being unable to meet debt payments.
“The financial system is [a] machine that’s shaking terribly because of all the stress put on it,” Mark Zandi, Moody’s Analytics’ chief economist, said to the WSJ. “The Fed is desperately trying to keep it from blowing a gasket.”
Corporate defaults are likely to level off at around 5.1 percent, Moody’s said, compared to about 4 percent currently. However, a worst-case scenario could send the rate as high as 13.7 percent, the ratings firm warned.
That would best the 13.4 percent that defaulted during the Great Recession.
Corporate defaults may not be the Fed’s chief worry at the moment, but could move to the fore “when that gasket blows,” Zandi said.
TREND FORECAST: The sea of corporate and consumer debt shadows the sunny headlines about the U.S. economy. As the Fed’s higher interest rates work their way through the economy, spending will slow further, jobs will be lost, and business activity will slow.
At that point, corporate defaults and bankruptcies will begin to rise more quickly.
That could have a snowball effect, taking business away from other companies that then would lack the cash to service their debt.
The corporate debt load is a key indicator to watch to see if the U.S. is approaching a recession. And that debt load crisis will increase especially in the commercial real estate sector. Across the spectrum, from the continuing death of the office building bust, the overbuilt warehouse sector, etc., the worst is yet to come.