Rising interest rates are a growing pain for businesses with junk loans

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Think rising interest rates are painful because of what it’s done to your mortgage? Talk to a CEO whose company has mortgaged its future on junk loans tied to every move of the US Federal Reserve.

The high costs of variable-rate loans, which rise with interest rates and are a popular tool for companies with less than stellar credit ratings, are beginning to weigh on companies with unsightly debt. They could have a wider impact on the buyout market – by putting a wrench in it.

In a Junk Funk

When a company takes out a leveraged loan, it typically agrees to pay a floating interest rate, which rises each time the Fed tightens monetary policy. While the Fed is expected to trigger several rate hikes in an effort to fight inflation, Citigroup expects the benchmark rates to which leveraged loans are anchored to climb to 3% next year, from 0.50% currently. That would mean a $45 billion increase in loan servicing fees just on loans originated last year, according to Dealogic data reviewed by The Wall Street Journal.

In 2021, corporate America took out a record $1.8 trillion in subprime loans. This year, Citigroup and Bank of America have warned that the cumulative portfolio is a growing risk. Because it carries a greater risk of default than investment-grade debt, a junk-rated loan can impose particularly onerous conditions on debt holders. Some businesses might start to feel the pain very soon:

  • Fashion giant Revlon has annual interest expense of $260 million, compared to just $206 million in cash in December, according to ratings agency S&P.
  • Technical equipment maker Encore Global, which issued $2.2 billion in loans at the end of 2020, is carrying unsustainable debt, according to Moody’s.

“It’s one of our biggest concerns and we’ve been tracking it in our portfolios since late last year,” says Somnath Mukherjee, chief investment officer at Lakemore Partners, a firm that invests in vehicles that own junk loans, says the Log.

Boom-to-bust: As private equity firms often pay deals with leveraged funds once borrowed by the companies they acquire, if loan costs continue to rise, the record $1 trillion takeover boom of last year could turn into a meltdown.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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