Sailing Through the Storm of Rising Interest Rates
We are moving away from an era of cheap capital. The US Federal Funds rate has increased by 25 Basis Points four times since December, 2015. The Bank of Canada overnight rate has had two hikes of 25 Basis Points in 2017. What can business owners expect?
Three things are happening.
1. The Interest Coverage Ratio is declining,
which will make debt re-payments more difficult to handle.
2. The Risk-Free Rate is increasing,
which reduces a company’s valuation.
3. The Middle Market hasn’t caught up yet,
meaning companies can still borrow at lower rates for a short time.
The “Interest Coverage Ratio” is used to determine how comfortably a company can cover its interest expenses on outstanding debt. It had already been weakening for several years before the first rate hike. The International Monetary Fund is projecting the Interest Coverage Ratio to decline even further (Figure 1).
The lower the ratio, the harder it is to make payments from operating income. The smallest 5% of S&P 500 firms with an asset value from $500 million to $3.5 billion (data from Yahoo Finance) feel the most severe effects from the deteriorating Interest Coverage Ratio (Figure 2).
Keeping everything else unchanged, when interest rates rise the risk-free rate also rises, causing a company’s future cash flow to be discounted by a larger number, resulting in a reduced company valuation. In the current marketplace, these same companies that feel the effects of rising interest have the disadvantage of a reduced valuation. If Institutional Lenders lend on the loan-to-value basis, a lower value will cause a lower loan advance rate.
Before the pricing for the Middle Market catches up, the credit market is extremely favourable for small and mid-sized business owners who can complete their debt financing prior to the end of 2017 (Figure 3).