Excessive rates of interest and financial uncertainty result in enterprise failures

Jerome Powell, Chairman of the Federal Reserve Board, departs after speaking during a press conference following the Federal Reserve Open Market Committee meeting June 14, 2023 at the Federal Reserve in Washington, DC.

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The Federal Reserve plans to raise interest rates further to curb inflation, meaning corporate default rates are likely to rise in the coming months.

The corporate default rate rose in May, a sign US companies are grappling with higher interest rates making it more expensive to refinance debt and an uncertain economic outlook.

There have been 41 defaults in the U.S. and one in Canada so far this year, according to Moody’s Investors Service, the most of any region worldwide and more than double the number for the same period in 2022.

Earlier this week, Fed Chair Jerome Powell said he expected further rate hikes this year, albeit at a slower pace, pending further progress in bringing down inflation.

Bankers and analysts say high interest rates are the biggest cause of distress. Companies that either need more liquidity or already have high debt loads and need refinancing must expect high costs for new debt.

Options often include distressed exchanges, where a company swaps its debt for another form of debt or buys back the debt. In serious cases, restructuring can also take place in court or out of court.

“Capital is much more expensive now,” said Mohsin Meghji, founding partner of restructuring and advisory firm M3 Partners. “Look at the cost of debt. At any given point over the last 15 years, one could reasonably get debt financing for an average of 4% to 6%. Now, the cost of debt is up to 9% to 13%.”

Meghji added that his company has been particularly busy in numerous industries since the fourth quarter. While the most troubled companies have been hit recently, he expects companies with greater financial stability to struggle to refinance due to high interest rates.

According to S&P Global Market Intelligence, as of June 22, there were 324 bankruptcy filings, not far short of the 374 total in 2022. As of April this year, there were more than 230 bankruptcy filings, the highest number for that period since 2010.

The Bed Bath & Beyond logo is seen at the store in Williston, Vermont on June 19, 2023.

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Envision Healthcare, a provider of emergency medical services, recorded its largest default in May. According to Moody’s, the company had more than $7 billion in debt when it filed for bankruptcy.

Home security and alarm company Monitronics International, regional financial institution Silicon Valley Bank, retail chain bed bath beyond and Diamond Sports, owner of a regional sports network, are also among the biggest bankruptcy filings so far this year, according to S&P Global Market Intelligence.

In many cases, those defaults last for months, if not quarters, said Tero Janne, co-head of capital transformation and debt advice at investment bank Solomon Partners.

“The default rate is a lagging indicator of distress,” said Jänne. “Often these defaults only occur when a number of balance sheet recovery initiatives have been well underway, and it is only in bankruptcy that capital shortfalls occur.”

Moody’s expects the global default rate to increase to 4.6% by the end of the year, above the long-term average of 4.1%. This rate is projected to increase to 5% by April 2024 before starting to decline.

“You can expect to see more defaults,” said Mark Hootnick, also co-head of capital conversion and debt advisory at Solomon Partners. So far, “we’ve been in an environment of incredibly lax lending, where companies that shouldn’t be using the debt markets have been able to do so, frankly, with no restrictions.”

This is probably the reason why there have been outages in various industries. There were also some industry-specific reasons.

“It’s not like there’s been a lot of defaults in any particular sector,” said Sharon Ou, vice president and senior credit officer at Moody’s. “Instead, there is a whole series of outages in various industries. That depends on leverage and liquidity.”

In addition to heavy debt burdens, Envision suffered from health issues stemming from the pandemic, Bed Bath & Beyond suffered from a large in-store presence while many customers opted to shop online, and Diamond Sports suffered from a surge in consumer demand for cable TV packages.

“We all know the risks companies are currently facing, such as slowing economic growth, high interest rates and high inflation,” Ou said. “Cyclic sectors like consumer discretionary will be hit as people cut spending.”

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