Driven in part by the recent rate hikes by the Federal Reserve, short term borrowing costs have spiked in 2018 creating a major headache for companies that are looking for new loans, as well as for companies like Colgate-Palmolive (NYSE: CL) and the Campbell Soup Company (NYSE: CPB) that have taken on floating-rate debt where interest expenses rise as rates do.
Part of that headache is because interest on that debt is typically linked to three-month LIBOR, which has doubled over the past year and recently reached its highest level in a decade.
The credit binge of the last several years has helped companies grow faster, and have allowed companies to do buybacks and offer higher dividends. But the rising levels of debt will undoubtedly make some businesses vulnerable when the next recession arrives. And as rates climb, cracks are already starting to show.
“The rise in LIBOR is really biting into the private sector,” David Kotok, the founder and chief investment officer at Cumberland Associates, said. “The free ride in the credit system is over.”
And Wall Street is already beginning to punish companies with high levels of floating-rate debt. As a Goldman Sachs report released on Monday noted, shares of S&P 500 companies with at least 5% of their debt in floating rate bonds had dropped 4% during Q12018, outpacing the S&P’s decline of 1% for the quarter.
Colgate-Palmolive and the Campbell Soup Company have at least 20% of their total debt in variable rate bonds according to the Goldman Sachs report. Other major companies with considerably high levels of variable debt include Stanley Black & Decker (NYSE: SWJ), General Electric (NYSE: GE), Conagra Brands (NYSE: CAG), and Textron (NYSE: TXT).
“These stocks should struggle if borrowing costs continue to rise,” Goldman Sachs analyst Ben Snider said in the report. Snider also noted that the share prices of these companies have “mirrored” the fluctuations in short term borrowing costs.
The concern isn’t that these companies won’t be able to pay off their debt, instead it’s that their interest expenses on that debt are rising from historically low levels which will eat away at profit margins.
“The backdrop of elevated corporate leverage and tightening financial conditions drives our continued recommendation to own stocks with strong balance sheets,” snider wrote in the report.
A recent report by S&P Global Ratings titled “Debt high, defaults low — something’s gotta give” noted that “Removing the easy money punch bowl could trigger the next default cycle.”
Excluding the very highly leveraged financial sector, corporate debt relative to GDP matched the all-time high during the third quarter of 2017, according to an analysis by Informa Financial Intelligence.
“It’s certainly a reason to be cautious, particularly when we are long into this growth cycle and the Fed is raising rates,” David Ader, chief macro strategist at Informa Financial Intelligence, said. “Everything is fine and well – until it isn’t.”