For my last Chart of the Week (COTW) in October 2022, I wrote about the shift in Federal Reserve (Fed) policy and how higher rates will put pressure on companies farther down the ratings spectrum.1 Those companies, generally rated lower single-B to CCC, typically exhibit weaker profitability and liquidity, as well as greater floating-rate exposure.
Companies with floating-rate exposure use either the London Interbank Offered Rate (LIBOR) or the Secured Overnight Financing Rate (SOFR) as their benchmark rates. In October 2022, those benchmark rates were between 3.25% and 4.00%. Currently, they are between 4.50% and 5.00%. With some exceptions, companies will face higher debt-service requirements (i.e., interest payments).2 The exception comes when companies hedge their floating-rate exposure, typically through the use of interest rate swaps.
For example, I follow a company that, on an unhedged basis, would be required to pay nearly $115 million in cash interest because the majority of its capital structure is comprised of floating-rate debt. However, it prudently decided to hedge its exposure and will instead pay a lower fixed rate for the next two years. At current rates, this decision will save them approximately $30 million a year in cash interest payments.
Taking a step back, we’ve seen some resilience in consumer spending habits, albeit mostly within luxury retail. As my colleague Jen Ripper outlined in her recent COTW, the consumer savings rate plummeted to 2.4% in November, from a recent peak level of 33.8% in the second quarter of 2020.3 Per the January Consumer Price Index (CPI) report, the “food at home” and “shelter” indexes rose 1.1% and 0.6% month-over-month, respectively, and are up 11.3% and 7.9% on a trailing 12-month basis.4
I believe we’re in the midst of an earnings recession, although an uneven one depending upon the sector in focus. For example, homebuilders continue to report elevated cancellation rates, chemical manufacturers have reported near-peak destocking and auto dealers are reporting lower year-over-year new and used car sales. On the flipside, many industrials have been supported by protracted backlogs and generally stronger demand, with added benefits from the flow-through of federal spending allocations from the CHIPS and Science Act, Inflation Reduction Act and the $550 billion Infrastructure Investment and Jobs Act.
There is a divergence between valuations and fundamentals. Technical indicators seem strong while earnings, especially through the second half of 2022, have disappointed. In the high-yield (HY) space, we’ve witnessed an influx of new issuance early in 2023, into a market that was starved of new supply in 2022.
Performance has been solid, with some of the new deals being heavily oversubscribed. Some of the issuance has addressed upcoming maturity walls in 2023 and 2024, and as companies saw an opportunity as yields came down from the fall of 2022. Interestingly, some HY companies have opted to extend maturities out only a couple of years in the hopes of another Fed pivot and materially lower yields. This, they hope, will give them another opportunity to refinance existing maturities at a lower coupon and reduce their debt-service requirements.
Key Takeaway
The earnings recession seems to be uneven. We’re faced with conflicting data and strong technicals, while most earnings are down sequentially and year-over-year. As the earnings strength fades for companies, their ability to generate cash will come under pressure. I favor companies that have solid margin structures, limited debt-service requirements and consistent free-cash generation.
Moreover, companies must face the reality of the new “hurdle rate” and the higher cost of capital as the 10-year Treasury yield, for example, rose more than 3% over the course of 2022. Just this past week, the 6-month Treasury bill rate touched 5% for the first time since 2007.5
In terms of an uneven earnings recession, some companies have extended backlogs that cover all of calendar year 2023 and parts of 2024. This should offer some stability in terms of topline growth, and these companies have highlighted a strong base level of demand.
To refer back to Jen Ripper’s latest COTW article, household leverage has risen and some borrowers have nearly exhausted their disposable incomes. Consumer spending on an inflation-adjusted basis has been stagnant, and I expect consumer demand and spending habits to contract through 2023. I continue to favor companies that either have contracted revenues or strong backlogs, and those that are coming off cyclical-trough destocking.
Sources:
1Source: Penn Mutual Asset Management- Look Out…Above: Weaker Credit Quality and Wider Spreads; 10/13/22
2Source: Bloomberg- 1-month/3-month LIBOR; as of 2/22/23
3Source: Penn Mutual Asset Management- Are U.S. Consumers Tapped Out?; 2/16/23
4Source: U.S. Bureau of Labor Statistics- Consumer Price Index Summary; 2/14/23
5Source: Bloomberg- 6-Month Treasury Bill Rate; as of 2/22/23
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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