How is Corporate Credit Handling a Higher Interest Rate Environment?

The Federal Reserve (Fed) raised interest rates to 5.5% to combat inflation starting in 2022; recent economic data has shown that inflation is beginning to slow, and now the market is expecting a rate cut. We spoke with IR+M to discuss how issuers have navigated this higher interest rate environment amid volatility, and if some issuers have fared better than others based on factors such as their sector and quality.

Rob Lund, CFA | Head of Consult Relations and Insurance Solutions Manager |
Income Research + Management
rlund@incomeresearch.com | Learn More >>

SAA: Which sectors are positioned better/worse for a higher interest rate environment? Are there sectors that would affect insurers more than others?

IR+M: Banks are better positioned for a higher interest rate environment as they benefit from higher rates, leading to improved net interest income (NII) and profitability. Technology issuers have also benefited from a higher interest rate environment as some issuers have put their large cash balances to work and generated interest income that has, in some cases, offset or surpassed their interest expense. The chart below highlights seven technology issuers that have generated more interest income than interest expense paid.

Chart 1: Technology Issuers Benefiting From Higher Interest Rates:

Two sectors negatively impacted by higher interest rates are REITs and Utilities, as both sectors are capital intensive and leverage the debt market routinely. Issuers will face higher debt costs as they refinance maturing debt or issue fresh debt to fund new construction or projects. Higher borrowing costs can lead to reduced profit margins and increased selectivity in pursuing new projects.

Insurers are typically conservatively positioned within fixed income and skew towards high-quality issuers. They tend to own fewer Financials and invest more into direct commercial real estate (CRE), which is exposed to higher interest rates, driving up the costs of borrowing for developers. Insurers exposed to companies with net cash positions amid a higher interest rate environment are best positioned.

SAA: Outside of sectors, what are factors that make an issuer more/less prone to credit profiles weakening in a higher interest rate environment?

IR+M: One factor benefiting investment-grade issuers is their ability to rely on fixed rate debt structures which allows them to mitigate the negative impacts of higher rates compared to high-yield issuers. Investment-grade issuers experience marginal interest expense increases as they refinance lower coupon debt at higher rates, but tend to have multiple levers to pull to offset that increase, such as reducing or pausing share buyback programs, divesting non-core assets, and alternative funding sources. On the other hand, high-yield issuers leverage floating rate debt structures that are more susceptible to higher rates.

Another factor that can impact an issuer’s credit profile is an unbalanced maturity profile. Investment-grade issuers can diversify their debt across the curve by utilizing longer maturities, such as 30-year and 40-year debt traches given their scale, financial policies, and large investor base, to name a few. However, high-yield issuers do not have the same ability to issue long-dated debt; typically, they issue debt with maturities of 10 years or shorter. Since their maturities are shorter than investment-grade issuers, high-yield issuers are forced to refinance their debt more frequently, and given the high interest rate environment, are doing so at a higher cost. The chart below shows the top-weighted index constituent from an investment-grade and high-yield perspective to highlight the maturity discrepancy.

Chart 2: Average Maturity For Respective Top-Weighted Index Constituent:

SAA: How are investment grade issuers handling this environment vs below-investment grade issuers?

IR+M: Investment grade issuers are typically globally focused and operate with simpler capital structures than below-investment grade issuers. This allows them to navigate the higher interest environment tactfully by leveraging various funding options available to them, such as commercial paper, short-term funding, and/or issuing debt in different currencies. Below-investment grade issuers have leaned into complex capital structures amid this environment, opting to utilize the convertible and securitized market to meet their capital requirements. For example, a high-yield Communication issuer tapped into the securitized market by issuing a Fiber asset-backed securitization (ABS) deal. The charts below show the use-of-proceeds breakdown by the investment-grade and high-yield universes. They show an increase in the refinance need for high-yield issuers while acquisition-related issuance has decreased across both universes.

Chart 3: Use-of-Proceeds Broken Out for US Investment-Grade and High-Yield:

Investment grade issuers are sophisticated bond market users and often public companies, which provides investors with increased transparency and comfort about their ability to navigate the higher interest rate environment compared to the high-yield space, where we see more private issuers and issuers with limited capital market track records. High-yield issuers are grappling with liquidity challenges by engaging in liability management exercises (LME) by coming to market to refinance, given the tight spread market we’ve seen this year, into longer maturities if their credit profiles have improved.

Source: Bloomberg as of 8/8/24 unless stated otherwise. Chart 2: IG Issuer is the top weighted non-financial issuer in the Bloomberg US Corporate Index. HY Issuer is the top weighted non-financial issuer in the Bloomberg US High Yield Corporate Index. Chart 3: J.P. Morgan as of 7/31/24, but published on 8/2/24. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable but IR+M makes no guarantee as to the accuracy or completeness of the underlying third-party data used to form IR+M’s views and opinions. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research + Management. This is not a recommendation to purchase or sell any of the securities or issuers in sectors listed above. “Bloomberg®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by IR+M. Bloomberg is not affiliated with IR+M, and Bloomberg does not approve, endorse, review, or recommend the products described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any IR+M product.

Source: Strategic Asset Alliance, Income Research + Management. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.