The companies that only survive on cheap money

US high-yield bond yields are hovering near 8.5 per cent. That is below the double-digit scares of recent months but still four times what companies paid to borrow during the pandemic, and it is testing a comfortable belief built up over a decade of cheap money, that solvency is an accounting matter more than a question of cash. A large group of weaker borrowers, companies that thrived only because capital cost nothing, now face a test of survival from their floating-rate debt.

The weakest spots are leveraged loans and unrated private credit. Public investment-grade companies locked in ten-year fixed coupons at tiny spreads. Middle-market companies owned by private equity mostly borrowed through floating-rate syndicated loans.

Fixed coupons buy time

The split matters because the two groups feel higher rates on different clocks. A company with a fixed-rate bond pays the old coupon until the bond matures, and many issuers used the record bond sales of 2020 and 2021 to push those maturities years into the future. A company with a floating-rate loan pays more from the next interest reset, usually within three months. The pain in the fixed-rate world arrives only at refinancing, while in the loan market it arrived this year.

Many private equity sponsors bought interest-rate caps when they closed their deals, which softened the first round of increases. Those hedges are short-dated, and as they expire the full rise in base rates passes straight through to the borrower.

Interest eats the cash

With benchmark SOFR going from zero to nearly 4.5 per cent, interest cover for B-minus borrowers shrinks fast. Take a business with debt at six times EBITDA that paid a 4 per cent all-in coupon and covered its interest 2.5x. It now finds interest swallowing more than seventy per cent of its free operating cash flow.

The arithmetic is unforgiving because nothing else has to go wrong. Doubling the coupon halves the cover, leaving barely more than a single turn of cushion before any fall in sales. Capital spending budgets get torn up, growth projects are cancelled and routine maintenance is put off, all to avoid defaulting on the loans. Private debt funds, which stepped in when nervous syndication desks pulled back, are signing amend-and-extend deals out of public view that hide how illiquid their portfolios have become.

Where the selling starts

The transmission runs through ratings. Collateralised loan obligations, the largest buyers of leveraged loans, usually limit their holdings of CCC-rated loans to 7.5 per cent of the portfolio. As weak borrowers are downgraded, CLO managers are pushed to sell into a thin market, which drives down prices and makes refinancing harder for the next borrower in line. The funds are not forced sellers of every loan, but they are rarely willing buyers of new CCC paper.

Zombies bleed slowly

The default cycle therefore looks less like a sudden wave of liquidations and more like a slow grind. Zombie companies rarely go under in one spectacular default. They lose viability bit by bit as free cash is diverted to senior floating-rate lenders.

The term has a working definition. The Bank for International Settlements counts a listed company as a zombie when its profits have failed to cover its interest bill for three years running and its market value suggests investors expect little improvement. By that yardstick the share of such firms in rich economies rose steadily over the decades in which interest rates fell, because cheap refinancing let companies survive that would once have been restructured. Higher rates reverse the process by making each rollover more expensive than the last.

History supports the slow version. The leveraged buyout boom of the late 1980s, financed with junk bonds, ended in a wave of defaults in 1990 and 1991, the same period in which Drexel Burnham Lambert, the market's dominant underwriter, went bankrupt. After 2008 lenders chose instead to extend maturities, a practice nicknamed extend-and-pretend, which spread losses over several years and kept companies alive that the market would otherwise have closed.

Who holds the risk

The losses will not fall where they did in 2008. Banks now hold relatively little leveraged debt on their own books; most of it sits with CLOs, loan mutual funds, insurers and private credit funds. Within a CLO, the senior tranches are protected by thick layers of subordination, so the pain lands first on the equity and junior tranches, which are owned largely by hedge funds and specialist managers.

Private credit funds are in a more awkward position. Floating rates have lifted the income on their loans, which flatters returns this year, but the same rates are what push their borrowers towards default. Pension funds and endowments that poured money into the asset class for steady yields are, in effect, the last line of loss absorption for a large slice of the private equity industry. The winners, for now, are lenders with fresh capital, who can demand higher coupons, tighter covenants and a share of the equity from borrowers with nowhere else to go.

The energy slump of 2015 and 2016 offers a smaller rehearsal. When oil prices collapsed, defaults among high-yield energy producers rose sharply while the rest of the market held up, and the losses were concentrated among the weakest borrowers in a single sector. This time the common factor is floating-rate funding rather than an industry, which spreads the damage across sectors but keeps it concentrated at the bottom of the rating scale.

Why defaults stay low for now

The strongest counterargument is that defaults remain low and the bond index is of higher quality than in past cycles, with a larger share rated BB. Companies also have cash left over from the borrowing spree of 2021. All of that is true, and it explains why the damage will be gradual. It does not change the cash maths for the floating-rate borrowers at the bottom of the capital structure.

The signals to watch are loan downgrades to CCC, the share of loans trading below 80 cents on the dollar, and the Fed's rate projections next week, which will show how long SOFR is likely to stay near its current level. A pause in rate rises would slow the squeeze. It would not reverse it unless rates fell.

Private equity owners are having to put in emergency junior capital or hand over control through debt-for-equity swaps. With high-yield borrowing at 8 per cent, unprofitable companies will fail as a matter of arithmetic, and they will probably go one at a time as their loans come up for refinancing over the next few years.