Overview
With rising rates pushing financing costs higher even as profits stagnate, leveraged companies in Europe are finding the relative costs of servicing their debts are climbing to increasingly difficult levels. This week’s Chart Room highlights our proprietary analysis of how this has dragged down interest coverage ratios across almost all sectors in the European senior secured loan market over the last year. According to our internal number crunching, we expect the cost of debt servicing to account for 36 per cent of earnings (ebitda) in the full year of 2023, up 13 percentage points from 2021.
Notably, during the worst of the pandemic, companies were on average paying around 32 per cent of their earnings to service debt – although this was driven more by a fall in earnings rather than an increase in debt costs. Now, a recovery in profits has been more than offset by rising rates, so much so that firms are paying an even higher share of their profits to service debt than during the depths of the Covid crisis.
Given that the average ebitda of the firms in our coverage universe is around €250 million ($273 million), we could see companies having to pay an extra €32 million a year on average to service their debts, rather than returning it to shareholders or investing it in growth.
To be clear, we don’t think this is likely to prompt a liquidity crisis. Companies still have a huge amount of flexibility around their cashflows and have barely drawn down their revolving credit facilities – we estimate that these lines will be around 13 per cent drawn in the full year 2023, down from 16 per cent in 2022. Similarly, it’s reassuring to note that there’s no looming maturity wall, and most companies will not be under pressure to refinance in this higher rate environment in the immediate future.
But the stress across the leveraged finance space will rise further. The market tends to place more leverage on borrowers from traditionally stable sectors, such as healthcare, telecoms, and software, and so these are some of the industries that are seeing their interest coverage ratios fall most markedly in the current environment (offset by strong visibility on revenues). We are also seeing the metrics shift for borrowers from the chemicals industry where earnings are falling as part of the cycle.
Still, casualties will arise - most likely among firms with less flexibility around their cashflows, or those whose business models were under pressure long before the rise in rates. There will be defaults. Navigating the riskier environment requires a large platform and careful, in-depth research. But sifting through to separate the wheat from the chaff is an increasingly delicate task – especially as interest coverage ratios may have further to fall.
