To better understand the potential effects of changing economic and operating conditions on U.S. speculative-grade credit ratings, we present our findings and insights from various stress tests to our 2022 forecasts. Below we explore the credit impact of a greater-than-expected rise in interest rates and inflation-induced profit squeeze and which sectors are most vulnerable to these risks.

Higher Rates And Inflation Pose Credit Risk For Highly Leveraged Corporate Issuers

Economic conditions are unraveling in the backdrop of a highly leveraged corporate America. There are two critical macroeconomic headwinds for U.S. issuers with speculative-grade ratings. The first is the expectation for a meaningful rise in the benchmark interest rates given the Fed's path to normalize policy rates (three months LIBOR was 0.2% at the start of the year and is at 1.52% now). The second is inflation and the potential deceleration in earnings because of higher costs and slowing demand. The combination of higher benchmark rates and spreads started putting pressure on funding costs after the Fed announced its intentions to tighten monetary policy in December 2021. It worsened with the start of the Russia-Ukraine conflict in February, which has had a severe impact on commodity prices and further stressed global supply chains. As a result, we saw higher inflation, worsening financing conditions, and deteriorating consumer sentiment. Expected increases in the Fed funds policy rate push it to around 3% by year-end 2022. The issue is further compounded by the Fed's impending plan to unwind its balance sheet, which may further disrupt financial markets.

Our rating distribution of nonfinancial corporate issuers has shifted considerably and now our most vulnerable issuers (rated 'B-' and below) account for 35% of all speculative-grade ratings. Additionally, the increase in first-lien debt because of easy financing conditions over the last two years indicates lower recovery rates in the event of a default. Nevertheless, many issuers have been able to pass higher costs to consumers, given high consumer savings and healthy demand. Companies began the year with healthy revenue and profits, an extended debt maturity wall (more than 85% of the leveraged loans in the LCD index mature in 2025 or later), and limited financial maintenance covenants giving them significant flexibility to avoid credit events and preserve liquidity. However, we expect profit margins to erode as the Fed attempts a soft landing. We currently estimate the likelihood of a recession within the next 12 months is within the 25% and 35% range.

Stress test methodology and assumptions

For this stress test, we obtained 2022 financial forecasts for about 1,600 U.S. speculative-grade issuers. On a median basis, our projections were from November 2021. We then increased cash interest costs by multiplying the stress rate increase by the last-12-month (LTM) reported debt balance. We stressed reported EBITDA margins on a percentage basis (for example, 5% stress to an EBITDA margin of 20% results in a margin of 19%). Aside from EBITDA and interest, we held all other 2022 assumptions constant and utilized median cash and reported credit measures to assess the credit impact.

Stress scenarios implemented:

• Modest: Increase cash interest 1%, 1.5%, 2.0%, and 2.5% (forecasted EBITDA margins held flat).
• Moderate: Increase cash interest 1.5% and reduce forecasted EBITDA margins 5%.
• High: Increase cash interest 2% and reduce forecasted EBITDA margins 15%.

Summary findings

In our modest-stress scenarios, there is limited rating impact in 2022. Risks increase in 2023 as higher interest costs take an increasingly larger bite of free cash flow.

Table 1

In our moderate-stress scenario, there is moderate rating impact in 2022, with increasing risk for 'B-' and lower issuers through 2022 and 2023.

Table 2

In our high-stress scenario, there is pressure on the ratings across all categories and downgrades are more likely in 2023.

Table 3

Data observations

• Given the limitations of our data set and our simplified stress scenarios, we believe the relative change in credit measures provides more information value than the absolute measures. In reality, we expect management to reduce risk-taking and costs to partially offset the expected economic and monetary impact of tighter financial conditions.
• Our summary conclusion utilizes median estimates and reported credit measures. We rate about 60% of our issuers 'B' and below, which results in a downward skew to our median results.
• The 1% increase in interest rates test within our modest stress scenario could be a reasonable proxy for how higher interest rates might move our 2022 interest expense forecast. It reflects the age of our data of 2022 forecasts, which on a median basis was from November 2021 when three-month LIBOR rates were less than 0.3%. Assuming LIBOR floors between 0.5% and 0.75% and a 1.4% average annual LIBOR rate in 2022, we expect an additional cash interest impact of between 0.6% and 0.9% than previously contemplated in our 2022 forecasts. Alternatively, using 4.8% as the average 'B' rating spread for new issuance over the last year plus annualized LIBOR rate of 1.4% in 2022, an all-in-yield of about 6.2% is below the median estimate of 6.5% in the 1% stress case.
• The actual cash interest rate impact will depend on the floating versus fixed interest debt proportions, expected tax shield, and any benefits from interest rate hedges. We note that many issuers rated 'B' or lower often only have floating-rate debt, maintain modest, if any, interest rate hedges, and are structured as LLCs that tax the company at a shareholder level. In addition, in 2022, the tax-deductibility of interest will decrease to 30% of EBIT compared with 30% of EBITDA in previous years, which could diminish the interest tax shield.
• Our interest rate stress reflects the expected rise in the benchmark rate but not the credit spreads that also widened sharply since our projections, which could increase pressure on speculative-grade issuers looking to raise new debt this year.
• On a median basis in our moderate stress scenario, the reported EBITDA margin of 15.7% is still higher than LTM levels of 14.7%. Accordingly, we expect our issuers will continue to benefit from the good cost pass through and lower one-time costs embedded in our 2022 projections.
• On a median basis, our high-stress scenario reported EBITDA margins are approximately 14%, about 4.8% or 70 basis points below LTM levels and just above 2019 levels. This scenario could provide insights into the 2023 impact if profit margins continue to roll over and the higher run-rate effect of interest rates.

Rate Increases Alone Will Not Lead To Significant Downgrades

Holding all other forecast assumptions unchanged, interest rates increases of 1%, 1.5%, 2%, and 2.5%, as a result of benchmark rate increases, are unlikely to present a significant risk to rating stability in 2022. Rate increases result in declining cash flow and the share of issuers with FOCF or EBITDA cash interest coverage deficits. However, our expectation for business growth and lower one-time costs partially offset the credit impact. In our most extreme case, where we increase interest rates 2.5%, we expect about 27% of issuers to experience negative FOCF up from our 2022 base-case expectation of about 15% but below LTM levels of 34%. In this case, median cash interest coverage falls to about 2.5x from 3.6x under our 2022 forecast.

Chart 1

We expect the Fed will manage its policy rate between 2.75% and 3% at year-end 2022. We believe the impact is limited in 2022, with most of the risk likely pushed into 2023, given the pace of the expected hikes and the cumulative effect of a rising interest rate curve. Benchmark rates increases of more than 2.5% for 'B-' and lower-rated issuers become more concerning if there are significant refinancing needs since credit spreads have also increased. However, most issuers face limited refinancing walls until 2024. The median FOCF to debt for the 'B-' rating category could fall to 1.5% from 3.8% if the total interest cost increases 2.5%. 'CCC+' and lower-rated issuers will face the more significant risks, given our view that many of these issuers have unsustainable capital structures and depend on favorable economic and business conditions to service debt. These issuers represent more than 8% of our speculative-grade rating portfolio, and we estimate the FOCF-to-debt ratio for many of these issuers could fall between -2.4% and -4% if interest rates increase 2.5%.

Rating Pressure Will Build Into Early 2023

In our moderate stress scenario, we increase cash interest 1.5% and decrease 2022 projected EBITDA margins 5%. This scenario assumes profitability improves from the last-12-month (LTM) levels, but less than previously expected because of an inability to pass through cost. This results in leverage increasing to about 5.2x (generally in line with LTM levels and up 0.26x from our forecast), and EBITDA cash interest coverage falling to 2.7x (down 0.93x). This implies the positive rating momentum among speculative- grade issuers over the last 17 months will likely stabilize or reverse. In this scenario, we would not expect many downgrades and believe issuers will have time to adapt their business and financial plans. In our high-stress scenario, we step up cash interest 2% and decrease 2022 EBITDA margins 15%. This scenario assumes issuers face significant difficulty passing through higher costs and EBITDA margins fall to just above 2019 levels. It results in reported leverage increasing to about 5.8x (up 0.9x from our forecast) and EBITDA cash interest coverage decreasing to 2.2x (down 1.4x). In this scenario, FOCF to debt drops notably below both LTM and 2019 levels.

Chart 2

'CCC' Category Is Most Vulnerable In A Modest Stress Scenario, But Downgrade Risks Are More Broad In A High-Stress Scenario

In our moderate stress scenario, 'CCC' category issuers and, to a lesser extent, our 'B-' issuers are most vulnerable to downgrades. 'B-' and lower issuers represent more than a third of the speculative-grade portfolio, and often has a high debt burden, modest liquidity profiles, and limited operating flexibility to offset cost pressures. We observed liquidity pressures in more than 60% of our 'CCC' category issuers and about 28% of 'B-' issuers. We would expect defaults to rise over the next 12 to 24 months if cash flow deficits persist as 'CCC' category issuers often depend on favorable business, financial, and economic conditions to meet their financial commitments.

Chart 3

In a high-stress scenario, the total number of issuers generating FOCF deficits could rise to 39%, up from about 22.5% in our moderate stress scenario and about 15% under our 2022 base-case forecasts. Weakness becomes more pronounced among our higher-rated issuers. Specifically, the share of issuer rated 'BB', 'BB-', and 'B+' that generate FOCF deficits increases 10.6%, 14.7%, and 17.4%, respectively, compared with our 2022 expectations. These issuers with cash flow deficits account for about 7% of the speculative-grade portfolio. Nevertheless, higher-rated issuers often have better competitive positions and liquidity profiles and have the flexibility to reduce their cost structures or adjust their operating, capital budgets, and financial policies (share repurchases and dividends) to offset shortfalls. The percentage of 'B' and 'B-' rated issuers expected to realize FOCF deficits jump to about 35% and 52%, respectively.

Chart 4

Cash balance serves as a strong cushion against downgrades, potentially reducing downgrade risk for 'B' and 'B-' issuers with projected FOCF deficits by roughly half in moderate and high stress scenarios.

The chart below shows the percentage of at-risk 'B' and 'B-' rated issuers as a percentage of all similarly rated issuers within the sector. To determine an at-risk cohort, we removed issuers with current cash balances more than three times expected cash flow shortfalls. The population decreased to about 12% from 26% of all 'B' and 'B-' with expected FOCF deficits in the moderate risk and 19% from 39% in the high-risk scenario.

Chart 5

Consumer-Facing Issuers Are Most at Risk In Our Stress Tests

Within the broader health care sector, health care services represent the most significant proportion of at-risk issuers. Currently, many of these companies face high wage pressure costs, limited access to qualified employees, and/or a difficult reimbursement rate environment. Restaurants and retailing at-risk issuers are primarily food services, restaurants, and miscellaneous retailers. Food services and restaurants have seen supply chain bumps, rapidly rising inflation, and labor shortages. We believe it is difficult for health care services, restaurants, and retailers to pass through costs, and we could see profit margins fall slightly in 2022. The media and entertainment at-risk group include issuers who could benefit from changing consumer preferences following COVID-19 lockdowns. For example, the at-risk group consists of many hotels and lodging issuers that are generally recovering since the omicron variant and as hotel average daily rate improves. Miscellaneous media and entertainment issuers, such as out-of-home entertainment, could see profit margins rise moderately as consumers purchase more services and entertainment experiences. Additional COVID-19 lockdowns could slow the expected improvements. The TV and radio at-risk group face secular pressure as consumers adopt streaming alternatives. The consumer products issuers include miscellaneous consumer products, consumer services, and food and kindred products issuers. These issuers face higher costs and supply chain issues like restaurants and retailers.

Applying These Findings

We believe the best way to use these findings is to combine our key insights with bottom-up fundamental issuer credit analysis. Although our stress scenarios are simplistic and bluntly applied to existing projections, they offer some insights into where the risks are highest and could provide a potential starting point for further fundamental analysis. Additionally, we could use them to quickly assess incoming economic and financial performance data and its broader impact on ratings. Finally, the findings offer an alternative benchmark to gauge alternative investor stress cases to see if they are roughly in line, somewhat more optimistic, or more pessimistic.

Related Research

• U.S. Packaged Food Companies Could Fail Additional Inflationary Stresses, April 21, 2022
• Macroeconomic Uncertainties Matter More Than Rising Interest Rates To Low-Rated U.S. Tech, March 29, 2022