This shift in focus is not dissimilar to how liquidity became a hot topic in the early days of the pandemic: with sales evaporating overnight, suddenly cash on hand and revolver availability was all investors cared about.

Back then, rates were near zero. Now, the dramatic rise in borrowing costs has brought cash back into the spotlight, but this time it’s crucial to consider it relative to total interest costs.

Alongside the interest coverage ratio (EBIT to interest costs), analysts also flagged the fixed-charge coverage ratio (EBITDA to fixed charges including interest, principal repayments, and leasing costs) and the ratio of levered free cash flow to total debt.

“It’s definitely become a much bigger focus,” said one credit analyst. “Leverage will never bankrupt a company, but liquidity issues will.”

Vibe shift

Traditionally, a company’s leverage — the ratio of debt to EBITDA — is the first metric analysts call upon to determine creditworthiness. It’s just one facet of a credit profile, but it gets lots of focus; it’s also one of the main measures the Fed uses in its leveraged lending guidelines.

But in an era of rising borrowing costs and eroding margins, this simple quantum is subject to more and more caveats. This is particularly true for companies with a large stack of floating-rate debt, given the dramatic rise in base rates.

“Debt to EBITDA and net debt to EBITDA, that's going to have to shift to focus on interest coverage, because the same amount of debt, same amount of leverage, is much more expensive on a go forward basis,” said a high yield portfolio manager.

One way companies can address this — if they have the resources — is to pay down debt. This could lead to a more proactive deleveraging cycle in months to come.

“To maintain the interest coverage that lenders are comfortable with, you're gonna have to have less debt,” said the PM. “So I think that's a big thing, that's a positive tailwind for credit."

On the flipside, companies that are struggling to meet investors’ higher expectations for interest coverage may have trouble accessing capital markets and thus find themselves at greater risk of a liquidity crunch.

“Based on our conversations with the buyside, we’ve been telling prospective borrowers that they need to be able to demonstrate to lenders that they can survive a higher interest burden in a rising rate environment,” said Moore at Union Square.

Baseline

To be clear, sources also noted that coverage ratios are still relatively strong on average across the leveraged finance universe, despite concerns about the impact of rising rates.

A report from JPMorgan in December noted that coverage ratios for leveraged loan-only borrowers reached a three-year high in Q3 2022 as earnings growth outpaced rising interest costs.

“[Interest coverage] is starting at such a high point for most companies,” said one high yield investor. “Companies were reporting record margins a year ago, and they were refinancing and terming everything out before the Fed started raising rates, back when spreads were extra tight.”

But the JPM analysts also said they expected coverage ratios to erode in the coming quarters, given the lag time between rate hikes and actual coupon payments.

The expectation is that the fourth quarter will be pivotal, as rising rates and a tougher economic environment are baked into annual results.

For now, one thing investors are trying to figure out is how much of their floating rate risk companies have hedged, and for how long. “This is why this fourth quarter is going to be kind of a pivotal moment for us,” said another portfolio manager.

But that’s not to say interest coverage in the meantime won’t be an issue for smaller issuers, especially in the loan-only space — or for sectors such as software, where companies were loaded with floating-rate debt by PE companies and are now seeing a slowdown in sales.

In times gone by, some credit agreements had covenants that would force companies to maintain a certain level of interest coverage. But after years and years of increasingly borrower-friendly documentation, lenders can’t rely on this any longer.

“You used to have interest rate requirements or coverage ratio requirements but more importantly, you had requirements of hedging,” said one high yield manager. “And those have gone out the window.”

TransDimes

Aerospace component manufacturer TransDigm has been flagged as one company where this shift in focus is playing out.

Over the past five years or so, TransDigm has operated with leverage in the region of 6x, according to recent earnings calls. This high leverage is an outlier for its credit rating bucket (currently B1/B+) according to Moody’s, which notes the company’s best-in-class margins.

TransDigm has historically pursued debt-financed acquisitions, and Moody’s also noted the company’s “recurring substantial shareholder distributions”. Essentially, leverage has been a fairly productive tool for TransDigm over the years.

Now, it may be forced to dial leverage back, largely because of rising interest rates. This may be the most effective way to maintain the 2x-3x interest coverage that TransDigm is comfortable with, said CFO Mike Lisman during an earnings call on November 10.

“We look at that ratio a lot now, more than we have in the past, along with the net debt to EBITDA ratio,” he said. “That's of equal [importance] or more important in this kind of rising rate environment.”

TransDigm has fixed the interest rate on over 75% of its $20bn debt stack through fixed rate notes and hedging arrangements, the company said on its latest Q1 earnings call on February 7. This gives the company some cushion against any rise in rates for now, Lisman said.

Back in November, he said that if those hedges weren’t in place, or if they were to roll off in the future, the company “might have to dial back the leverage a bit to sort of hit the EBITDA-to-interest coverage ratios”.

Earlier this month, TransDigm was one of several issuers that tapped the bond market to reduce its reliance on floating rate, as the rise in SOFR begins to impact loan coupons. The company priced $1bn of 6.75% SSNs due 2028 alongside a $4.56bn TLB due 2028.

Ratings pressure

The threat of rating downgrades is part of the reason why analysts are focusing so closely on interest coverage and other related metrics these days. Indeed, rating agencies themselves may consider this metric when making upgrade or downgrade decisions.

CLO managers in particular are wary of loading up on single-B debt, mindful of the risk of downgrades. CLO structures usually limit the total exposure to triple-C credits to 7.5% of the portfolio, after which point there may be consequences for investor returns.

“We do expect to see corporate downgrades because of the impact of higher rates on levered companies, but our base case expectation is not to see a lot of CLO downgrades,” said a director at a ratings agency.

The proportion of the Morningstar LSTA US Leveraged Loan index that is rated B- (one notch above the CCC bracket) has climbed to around 25% as of January 2023, up from around 14% at the end of 2019.

“The market has more single-Bs in its constituency than ever, so investors are worried about downgrades,” said a CLO manager. He said he expected single-B credits to have around 5% free cash flow to total debt, and double-Bs to have more like 10%.

“If your free cash flow isn’t 1.3x interest, or free cash flow to debt is around 2%-3%, you’ll be on negative outlook,” he said. “This has always been a part of credit analysis, but free cash flow wasn’t really a problem for the last 10 years, when rates were so low.”

If a CLO fails the triple-C test, it may also fail its junior overcollateralization test, which could cut distributions to equity investors (solving this threat by simply enlarging the triple-C bucket isn’t really seen as a workable solution by most managers).

Data suggests that most CLO managers still have some headroom in triple-C baskets. As of January 12, triple-C rated debt accounted for around 5% of US CLO exposures, according to S&P data.

But that could change if a significant amount of B- loans are downgraded. If 20% of those loans receive a ratings cut, triple-C buckets could rise to 10%-11% on average, said the rating agency director.

“A lot of downgrades would have to happen before average triple-C buckets breach the 7.5% limit,” said the ratings agency director. “To burn through that cushion would take a lot.”