Short-term borrowing rates are rising to the point where some heavily indebted U.S. companies can no longer ignore them.
A benchmark for near-term borrowing, the three-month U.S. dollar London interbank offered rate, has risen above 0.75 percentage point. That's a key threshold for junk-rated companies with about $230 billion of loans outstanding according to data compiled by Bloomberg — with Libor above that level, the borrowers will have to pay more interest over time. The increase so far could amount to about an extra $230 million of total interest expense annually for the companies.
Companies that took out floating-rate loans knew they would have to pay more to borrow once rates started rising, but they haven't experienced real increases for years. Even when the Federal Reserve started hiking rates in December, many companies did not have to pay higher rates on their loans until Libor breached key levels, because of the way their floating rates are calculated. Rising interest payments would only add to pain for U.S. borrowers that are already suffering from falling profits and higher default rates. And Libor could rise further — JPMorgan Chase & Co. strategists recently forecast it could reach 0.95 percentage point by the end of this month.
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There will be some companies "for which it might become an issue," said Neha Khoda, a high-yield credit strategist at Bank of America Corp. With Libor having risen above key levels like 0.75 percentage point, many issuers have to think about how they will pay the extra interest, she said. Three-month Libor now stands at 0.85 percentage point, and has been rising as new money market fund rules curb investor demand for companies' short-term debt.
Interest rates on loans in the leveraged loan market are calculated by starting with a benchmark borrowing rate like three-month Libor and adding a margin known as a "spread." About $230 billion of the loans in the market have a minimum benchmark level, or "floor," equal to 0.75 percentage point, meaning that even if Libor has fallen below that level, the borrower must pay the minimum plus the spread. Most of the debt in the $900 billion leveraged loan market has Libor floors, which are often set around 1%.
'Rational Decision'
Floors grew popular when interest rates started plunging after the crisis, and are meant to cushion lenders against falling rates. Many companies have a combination of fixed- and floating-rate obligations, and the variable-rate debt can be hedged to reduce exposure to interest rates.
Libor is rising in anticipation of new rules for money market funds that go into effect in October. Under the regulations, investors in funds that buy short-term corporate obligations can suffer losses when the value of the assets falls. Funds that only invest in short-term government debt are not subject to the new rules, which has made government-only money market funds much more popular in recent months.
As investors have had less demand for funds that invest in short-term corporate debt obligations, issuers have had to boost yields, lifting benchmark rates.
Libor's rise is also a function of changes to the way the rate is calculated after years of scandals revealed flaws in the method for setting the levels, according to Peter Tchir, head of macro strategy at Brean Capital.
"There's been a huge focus on the regulatory changes but the way Libor has been calculated has been changing and that has a lot to do with the rise too," he said Tuesday by phone. "This is why we think Libor is going to continue to be elevated relative to other rates and why we think investors should boost exposure to floating rate notes."
Some borrowers may look to change the benchmark rates on their loans to switch to lower baselines, such as one-month Libor, said Craig Russ, a portfolio manager at Eaton Vance Corp. that invests in loans.
Advanced Disposal Services Inc., the Ponte Vedra, Fla.-based waste manager, did so earlier this year, according to e-mailed comments from the company. The company had a $1.69 billion loan with a floor on three-month Libor of 0.75 percentage point. In the second quarter, it switched to one-month Libor, which is currently 0.53 percentage point. Advanced Disposal has posted at least five years of annual net losses according to Bloomberg data. It has filed for an initial public offering whose proceeds would help pay down debt.
Whether the one-month Libor rises like the three-month and six-month rates did remains an "open question," according to JPMorgan Chase analysts led by Alex Roever. But it still may make sense for many companies to try switching to one-month Libor to increase their chances of their benchmark staying below their floor, Eaton Vance's Russ said.
"It's a rational economic decision to lower your costs," Russ said. "If you're the CFO of a company, you'll probably want to prevent yourself going above the Libor floor."
Bloomberg News
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