Loomis on Loans - Q1 2022
We are often asked: how will rising rates affect the capital structures of the companies to which we are lending? Are interest rate hikes likely to cause a strain? We have looked at that answer in the past when rates threatened to rise, and the simple answer for most of the credits we follow is: no, rising rates are generally not a problem. In this edition of Loomis on Loans, we lay out how to look at some of the impacts of the rising rate question.
First, we think it is important to note that rates do not rise in a vacuum. In general, rates should be rising when the economy is relatively strong and growing. If that is the case, then company cash flows should be rising with rates, offsetting some or even all of the effect of rates on profitability. In addition, most borrowers in our market hedge rates (at the request of their lenders, if for no other reason), so there should not be a one-to-one relationship between rising rates and greater interest expense on the income statement. Further, companies facing rising rates can modify their spending in various ways if they are expecting interest rates to squeeze their cash flows. But we must also recognize that if rates rise TOO much, recession risk can rise and reduce earnings. We will assume in the examples below that rates rise, there are no offsets, but they do not rise so much that a recession is triggered.
The most important question we think about is whether a capital structure is adequately capitalized. Is the company’s balance sheet built to withstand what the world is likely to throw at it, including rising rates? In the pandemic, we saw that most balance sheets could take the pain caused by fluctuating demand. Default rates were very low among the relatively large companies that issue broadly syndicated loans.
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