The Big Idea

The impact of higher rates on investment grade credit

Steven Abrahams and Dan Bruzzo, CFA | November 3, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Higher rates affect credit when they translate into higher borrowing costs, but that only occurs gradually. The pace at which existing debt rolls over into new debt at a higher rate of interest depends on maturities. Based on the existing coupon, maturity and estimated new coupon of more than 10,000 US investment grade corporate bonds, those issuers are likely to see a proportionately slower rise in interest expense over the next few years than the US Treasury. But unlike the Treasury, rising interest expense is likely to trigger wider spreads and more rating actions from agencies.

US companies have 10,140 public debt issues listed on Bloomberg with a par balance of $8.91 trillion. Given low absolute rates and attractive spreads available starting in mid-2020, many investment grade issuers decided to add leverage and migrate down the rating scale. More than 47% of the current outstanding par carries ‘BBB-‘, ‘BBB’ or BBB+’ ratings with another 44% carrying ‘A-‘, ‘A’ or ‘A+’ (Exhibit 1). A scant 9% carries higher ratings.

Exhibit 1: Most outstanding investment grade debt sits at the low end of the scale

Note: Issues outstanding as of 31 Oct 2023.
Source: Bloomberg, Santander US Capital Markets

All of these issuers will face the choice of whether to roll their debt at maturity, and the vast majority will. Companies trying to deleverage and companies with big cash stockpiles may be the exception. Everybody else will either need to issue new bonds to replace old, take out a bank loan or find some other lender. But luckily for the average investment grade corporate issuer, less than 7% of outstanding issues mature when it is likely the Fed will keep policy rates high over the next year (Exhibit 2). The share of issues maturing in later years rises, with 67% maturing over the next 10 years. To put some of that in context, more than 20% of marketable US Treasury debt matures over the next 13 months, nearly triple the share of investment grade debt maturing in the next year.

Exhibit 2: Less than 7% of IG debt matures in the next year, 67% over 10 years

Note: Issues outstanding as of 31 Oct 2023.
Source: Bloomberg, Santander US Capital Markets

The impact of upcoming maturities on corporate interest expense depends on simple arithmetic, assuming the issuer rolls the full par balance: the new coupon minus the old. While the old coupon is known, the new coupon is not. That’s where the artwork comes in. To put a flag in the sand around the impact of higher rates on interest expense, we have to make a few assumptions:

The issuer rolls the full par balance. An old $100 million issue will get rolled into a new $100 million issue.
The issuer rolls into the same tenor as the original debt. A 10-year bond with one year to maturity will get rolled into a new 10-year bond.
The par yield curve at each rating notch stays constant. Each rating category from ‘BBB-‘ to ‘AAA’ has a unique par or fair value yield curve, estimated by calculating a smooth curve relating yield to maturity using outstanding issues. And that curve stays constant.
The spread of each debt issue to its par rating curve stays constant. If a 10-year ‘BBB-‘ bond with one year to maturity trades at a spread of 25 bp to the 1-year point on the ‘BBB-‘ par curve, then the new bond will get issued at a spread of 25 bp to the 10-year point on the ‘BBB-‘ par curve.

Under these assumptions, the interest rate on debt rises in every rating category—slightly over the next year, and significantly over the next 10 years (Exhibit 3). Debt with an ‘A+’ rating stands out for the magnitude of increase over both one and 10 years. This reflects the heavy presence of banks in this rating category—bank debt makes up 44% of ‘A+’ issues maturing in the next 10 years while making up only 24% of all issues outstanding—and the relatively wide spreads where banks currently trade. To again add context, the interest expense on marketable Treasury debt also rises over the next one and 10-year, and by a higher multiple than the corporate categories.

Exhibit 3: Steady high rates would lift interest expense across all IG ratings

Note: All data and market levels as of 31 Oct 2023. Fair value curves calculated by selecting all issues at a given rating and estimating a loess model with YTM a function of time to maturity. The loess model used to estimate a continual par maturity curve. Spread to fair value estimated for each issue as current YTM relative to fair value at same maturity. New debt coupon estimated as fair value YTM at original tenor plus spread to fair value for the particular issue.
Source: Bloomberg, Santander US Capital Markets

The relative impact of persistent high rates is easier to see by looking at the percentage increase in interest expense at each rating category. If a company currently spends $1 on interest expense and rolls that a year later into debt requiring $1.04 in interest expense, for example, the percentage increase would be 4%. This kind of comparison shows the percentage increase over one year in ‘BBB-‘ to ‘BBB+’ debt ranges between 4% and 5%. For ‘A-‘ to ‘A+’ it ranges between 5% and 16%. For ‘AA-‘ to ‘AA+, it ranges between 8% and 12%. And for ‘AAA’ it is less than 9%. To again add context, interest expense for the US Treasury, which is heavily funded with short debt, would rise 16% over the next year, far faster than almost every category of investment grade debt.

Exhibit 4: Estimated percentage increase in interest expense over 1 and 10 years

If interest rates remained high over longer horizons and issuers continued to roll, the impact on interest expense goes up dramatically. Over 10 years, interest expense across rating categories rises between 33% and 76%. By comparison, interest expense for the US government would rise only 34%.

Beside differences in the pace of change in interest expense, the biggest difference between corporate issuers and the US government is the likely response of investors and rating agencies. Unless earnings keep pace with rising interest expense—something progressively harder for a company to do as its debt load rises—then the ratio of earnings to interest expense will start to fall. That ratio, along with the volatility of earnings, determines the likelihood that a company will lack enough earnings to completely cover interest and will have to start borrowing from other lenders or start burning cash to cover the shortfall. Adding leverage or burning cash is not a good look either for spreads or rating agencies. Some companies will have the flexibility to draw on deep pools of balance sheet cash or put off mergers or acquisitions or other big expenses and simply not roll debt. But unless interest rates continue the steep decline of the last few trading sessions, even investment grade issuers look likely to come under steady pressure from interest expense over the next year and beyond. The lower in credit, the greater the pressure.

“The most important thing,” Fed Chair Powell noted after the recent FOMC, “is that these higher Treasury yields are showing through as higher borrowing costs for households and businesses.” The longer Fed policy and market expectations keep rates high across the curve, the greater the drag on investment grade credit.

* * *

The view in rates

OIS forward rates now price almost no chance of another Fed hike. The same forwards then see rates declining 91 bp from March through December 2024. Fed Chair Powell after the November FOMC described risks as “more balanced,” presumably meaning no tightening or easing bias. The market consequently may have the implied easing wrong. The Fed path may pin 2-year rates around 5%, but the lack of a clear tightening bias should help longer rates to slowly rally.

Other key market levels:

Fed RRP balances closed Friday at $1.07 trillion as the facility continues to decline, down $20 billion in the last week but down $487 billion since September. Money market funds continue to move cash out of the RRP and into higher-yielding Treasury bills.
Setting on 3-month term SOFR traded Friday at 538 bp, unchanged in the last week
Further out the curve, the 2-year note closed Friday at 4.84%, down 16 bp in the last week. Given the likely Fed path, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.57%, down 26 bp in the last week. At that yield, the 10-year note looks attractive relative to many risk assets.
The Treasury yield curve closed Friday afternoon with 2s10s at -27, flatter by 10 bp in the last week. The 5s30s closed Friday at 26 bp, steeper by 1 bp in the last week.
Breakeven 10-year inflation traded Friday at 240 bp, down 2 bp in the last week. The 10-year real rate finished the week at 218 bp, down 23 bp in the last week.

The view in spreads

The lack of a clear tightening bias and a Fed shift to “more balanced” risks should reduce rate volatility and help spreads. The Bloomberg investment grade cash corporate bond index OAS closed Friday at 157 bp, tighter by 5 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 167 bp, tighter by 20 bp in the last week. Par 30-year MBS TOAS closed Friday at 61 bp, tighter by 23 bp in the last week. Both nominal and option-adjusted spreads on MBS have snapped tighter after the November FOMC. That likely reflects mutually funds suddenly less worried about redemptions and liquidity and more interested in relative value in MBS.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, but a lot will depend on how long rates remain high. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B’ and ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

Dan Bruzzo, CFA
dan.bruzzo@santander.us
1 (646) 776-7749

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