If interest rates go higher, struggling companies that borrowed too much debt could be in big trouble—something that investors aren’t prepared for, contends an article in The Wall Street Journal. The riskiest section of the bond market has beaten the rest, and CCC-rated borrowers that are dangerously close to defaulting have generated 10% returns so far this year. Meanwhile, the safe AA-rated corporate bonds have returned a mere 2.7%.
But only the shareholders at smaller companies seem concerned; large companies with struggling balance sheets are still outperforming those with more solid inflows. Those struggling companies have benefited from the recession that didn’t materialize and lowered inflation, while credit-worthy companies didn’t gain as much because interest rates stayed high. However, rate hikes aren’t over, and the economy will suffer because it will have to support those indebted companies, the article maintains.
There are three different types of weak companies. The first type are the highly-speculative that enriched themselves at the end of the post-pandemic boom, mainly from SPACs, such as second-tier EV startups. Soon their business model will implode, taking them down with it. Their downfall isn’t much of a surprise, much more so than the second type of company: solid businesses with steady cash flows that took on too much debt when free money was pouring into the economy. As rates rise, that debt will be harder to maintain, and even businesses whose core operations are profitable are running into trouble. Such is the case with the U.K. water supplier Thames Water, which is paying more for its debt while hemorrhaging money to manage its business, and French supermarket chain Casino Guichard-Perrachon that is currently working out a debt-for-equity exchange. Meanwhile, the third type of company should be doing well: those whose earnings swing up and down and don’t carry too much debt. But because of that higher volatility, they will be unable to borrow much from cautious lenders, the article explains. Indeed, the S&P 500 stocks with more volatility have beaten those with lower volatility, such as Ford and GM, but the risk those companies bring to the economy is from financial engineering by private equity. When those companies go to refinance, it will be much more expensive.
The first type of company isn’t likely to be saved by those willing to risk a wild bet, while the second will suffer more in the face of their debts, and the third type of company could see a big decline once the Fed slows down the economy. Investors who believe that the Fed isn’t done tightening and that the central bank will remain hawkish in an effort to tamp down inflation should avoid investing in any of these three types of companies and stay out of the “dash for trash” race.
