Rising Interest Rates Could Crush Some Small Caps

Nonfinancial corporate debt is at a record high, and for some companies the leverage is unsustainable, says an IIF paper.
Vincent RyanAugust 31, 2017
Rising Interest Rates Could Crush Some Small Caps

The total debt of nonfinancial U.S. corporations is at record levels, but is it a looming problem? Yes, at least for some companies, and despite low interest rates and high levels of balance-sheet cash.

According to the Institute of International Finance’s latest capital markets monitor report, “U.S. Corporates’ Net Debt: An Uneven Burden,” in the last 10 years “U.S. corporations have experienced a deterioration in their ability to pay interest on outstanding debt.”

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In addition, by 2018, the problem may become acute for companies with a market capitalization of less than $1 billion.

“While leverage has increased across the board (both on a gross and a net basis), small-cap firms in particular have an increasingly serious problem with interest payment capacity — leaving them quite vulnerable to rising interest rates,” according to the IIF paper.

The authors, led by Hung Tran, an executive managing director of the IIF, examined a dataset of about 3,000 U.S.-headquartered firms listed on U.S. stock exchanges.

The group of companies had an accumulated debt load of $6.9 trillion at the end of the second quarter of 2017, compared with $3.1 trillion in 2007. Combined, their balance sheets also held $2.2 trillion in cash, cash equivalents, and short-term investments (versus $0.9 trillion in 2007).

Segmented by market capitalization, the group consisted of 1,545 small-cap firms (market cap of less than $1 billion), 866 mid-cap firms (market cap between $1 billion and $5 billion), and 613 large-cap firms (market cap of more than $5 billion.)


The issue is that cash holdings and debt burdens are distributed unevenly. While the large-cap companies combined have the most cash, their debt-to-cash ratio of 2.8 ($1.9 trillion in cash, $5.4 trillion in debt) was lower than that of the mid-cap (debt-to-cash ratio of 4.8) or the small cap (3.4) groups.

Small-cap and mid-cap firms had relatively stable debt/equity ratios over the 10-year period (18% and 62%, respectively), while large-caps pushed their leverage to a record high of 83% (compared with 50% in 2007), write the authors.

However, when it comes to measuring debt to earnings, actually what the authors label “gross debt to earnings before interest and tax,” small-cap firms show the largest increase in leverage since 2007, at 3.5x.

Small caps also have the poorest interest coverage ratios (ICR), which reflect “companies’ ability to pay interest on their debt out of current earnings.” The median ICRs (a ratio of EBIT to interest payments) of the small-cap companies in the group fell to what the IIF calls “essentially nil” in 2017, down from 2.7x in 2007. That essentially means, the IIF authors note, that these companies “have to run down their assets or borrow more just to pay interest on outstanding debt.”

Any company with an ICR below 2.0 (which the IIF calls “stressed”) will be “quite vulnerable” to any further increases in interest rates going forward, say the IIF authors. (About 20% of the firms examined fall into the “stressed” category.)

The Federal Reserve’s unwinding of its balance sheet could also pressure these borrowers, especially if they have high-yield debt outstanding, say the authors.

The process of reversing quantitative easing in the United States could raise high-yield spreads by 300 basis points by the end of 2018, which would result in a 0.8 points decline in the median ICR of high-yield borrowers. The IIF calls that a “substantial deterioration that would have negative implications for corporate creditworthiness.”