If rates were to pop up significantly over the next year hundreds of companies’ credit quality would take a dive. That’s according to rating agency Standard & Poor’s. Using its basic financial risk methodology, S&P analyzed 10,100 companies’ financials and found that an immediate rate hike of 4 percent to 6 percent, which it acknowledges is unlikely, would result in 17 percent of corporates suffering a material drop in credit quality.
The rating agency anticipates the US Federal Reserve to begin raising it funds rate in second-quarter 2015 until it reaches 3.75 percent by third-quarter 2017, giving corporates globally plenty of time to adjust their operations and maintain their credit profiles. Nevertheless, more significant and rapid rate hikes are within the realm of possibility, given central banks’ use of creative and untested monetary policies and plenty of economic unknowns.
The S&P analysis essentially represents a snapshot in time from December 31, 2013. David Tescher, a managing director at the rating agency, said S&P’s goal was to do a simple analysis applying only the core credit ratios to indicate where credit challenges could arise. The study analyzed key cash flow and leverage ratios and the agency’s country and industry assessments on both rated and unrated companies to arrive at credit scores, leaving out less tangible factors such as management and business risk profiles that are a part of actual ratings.
“This effectively shocks the balance sheets at point in time with three scenarios of interest rate rises,” Tescher said.
The analysis was applied to companies’ floating rate bank debt, which would be vulnerable to rate rises. Tescher noted that many companies have taken advantage of historically low fixed-rate debt, a factor mitigating their credit risk. He added that the analysis, while approaching a year old, remains a “good proxy” for companies’ current ability to handle sharp increases in rates, since they’re been prepping for an increase for a couple of years now.
“Companies have tried to strengthen their balance sheets and retain liquidity in case of a capital markets disruption,” Tescher said, noting those efforts as a mitigating factor, although companies’ leverage has increased as they’ve taken advantage of historically low rates.
The study found that the credit metrics of corporates in real estate, transportation, healthcare, and iron and steel appear most sensitive to an interest rate rise. Meanwhile, corporates in China, Germany, the UK and the US have below-average interest rate sensitivity, whereas those in Brazil, France, Italy, Japan, Korea, and Spain have above-average sensitivity.
The study also looked at two less severe interest-rate-increase scenarios. It found that a sudden increase of 2 percent to 3 percent would result in a one-deterioration in credit scores among 8 percent of corporates, and that percentage jumps to 13 percent for an increase of 3 percent to 4.5 percent.
The report notes that given the economic challenges faced by Japan and the Eurozone, S&P anticipates central banks in those regions to keep short-term rates near zero and longer term rates low, so it anticipates debt servicing costs there to remain low compared to the US over the medium term.
“Consequently, the scenarios in this article are far more hypothetical for Japan and eurozone than for the US,” the report says.