(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2024—collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2024.)
Interest cost pressures and a difficult economic backdrop mean credit pressures will remain acute for weaker borrowers.
How This Will Shape 2024
Weaker economic growth and a rising interest burden will test corporate issuers globally. The corporate sector proved surprisingly resilient in 2023, with sustained consumer spending, notably in the U.S., and supportive tailwinds from capital investment. Still, difficulties are apparent with default rates edging higher, net downgrades, and contracting annual revenues and EBITDA. The challenges will grow in 2024, as higher interest costs continue to filter through to effective interest rates, refinancing pressures start to build and the economic backdrop remains difficult.
Corporate decision-making will likely amplify broader economic trends. Continued resilience and a gradual rebound in profits would likely contain credit pressures to the most vulnerable. This could start to unlock cash balances for M&A and investment. However, if the global economy weakens more than our forecasts assume, companies will likely act quickly to protect cash flows through layoffs and investment cuts, traditional harbingers of recession.
Charts 1 and 2
What We Think And Why
Interest rate and refinancing pressures will continue to bear down on corporates. Third-quarter results to date show cash interest payments still surging, up 21% at an annual rate and 25% for speculative-grade entities overall. Third-quarter results showed cash interest payments still surging, up 21% at an annual rate and 25% for speculative-grade entities overall. Refinancing conditions remain difficult, particularly for weaker entities, with lending standards tightening and debt maturity pressures building next year.
We think structural changes are at play that will put pressure on unsustainable capital structures. The era of ever cheaper borrowing costs is over (see chart 1), as is the steady uptrend in profitability wrought by globalization, muted labor cost inflation, and reduced energy intensity. Trade and political tensions are unlikely to fade in the near term, although artificial intelligence (AI) may be a productivity wildcard. Sustained higher financing costs will likely mean that credit metrics such as interest cover, which had ceased to be of much relevance, will again be of value. More broadly, the end of financial repression (defined as interest rates being held below the inflation rate) may bring risks from unsustainable capital structures to a head.
Credit pressures are likely to be confined to the weakest credits. Despite these pressures, we believe credit quality will remain robust in investment grade and the stronger parts of speculative grade, absent a severe economic contraction, and allow a modest turnaround in the earnings cycle (see chart 3). However, the weaker end of the credit spectrum is vulnerable. We estimate median EBIT interest cover for U.S. 'B' rated nonfinancial corporates will drop below one by the end of this year to 0.6x, its lowest level since Q3 2004, and remain below one in 2024 (see chart 2). Among U.S. 'B' category ratings, 11% have had EBIT interest coverage ratios of less than one for three years or more (see chart 3), showing further evidence of fragility. For these reasons, we expect default rates will continue to rise even if the broader story is one of recovery.
Charts 3 and 4
What Could Go Wrong
Sustained inflationary pressures or a sharp economic contraction are the primary risks. Prolonged or reignited inflation pressures would exacerbate the already significant impact of higher interest rate costs, and likely be accompanied by intensified labor cost inflation and margin pressure. A sharp economic contraction could entail a dangerous combination of falling EBITDA and still elevated financing costs, with market volatility and higher risk premia likely to overwhelm any benefit from the lower policy rates that would likely follow.
Read More
- Corporate Results Roundup Q3 2023: Deterioration continues and revenues disappoint, Nov. 16, 2023
- Interest-cover risks are growing for vulnerable corporate credit, Oct. 26, 2023
This report does not constitute a rating action.
| Primary Contacts: | Gareth Williams, London + 44 20 7176 7226; gareth.williams@spglobal.com |
| Gregg Lemos-Stein, CFA, New York + 212438 1809; gregg.lemos-stein@spglobal.com |
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