Stubbornly high interest rates risk squeezing UK companies

LONDON – Britain is facing a “double whammy” as higher-for-longer interest rates begin to bite, with the country particularly vulnerable to a pullback in consumer spending and knock-on consequences for corporate debt.

The Bank of England (BOE) warned this week that the full impact of elevated borrowing costs has yet to fully pass through, although about two-thirds of British adults have already cut back on discretionary purchases and retail sales are almost flat by volume.

More households are also turning to credit card debt, which is growing by double digits annually.

The country’s weak level of investment puts more weight on consumer spending, said Professor John Van Reenen of the London School of Economics.

“This becomes a double whammy because UK rates have risen more sharply and Britain relies more on consumption,” he added. “These heavy chains are pulling down our growth prospects.”

Strong growth would help firms grappling with higher borrowing costs to boost revenue and service their debt.

Instead, Britain is expected to remain stagnant, with the International Monetary Fund slashing its forecast for next year from 1 per cent to 0.6 per cent this week.

A consensus estimate compiled by Bloomberg is even lower, at 0.4 per cent.

More than US$15 billion (S$20.4 billion) of British corporate debt is trading at distressed prices, according to data compiled by Bloomberg News – up nearly 50 per cent since late September.

One in two companies is likely to face stress in servicing debt by the end of the year, the BOE has warned, which could cause some owners to cut investment and employment sharply.

The reliance on consumer spending also filters into the debt markets.

About 35 per cent of high-yield bonds and leveraged loans issued by British firms are in the consumer discretionary sectors, according to data compiled by Bloomberg, making the industry potentially more vulnerable to a recession than the rest of Western Europe, where it makes up 26 per cent of the market.

The vulnerability, in turn, harms the attractiveness of British corporate debt.

On top of that, the BOE’s quantitative tightening programme, in which it is selling off bonds bought during a decade of almost free money, is causing spreads to narrow, making company bonds issued in sterling less appealing.

Property woes

One reason for the weakening consumer market is that mortgage payments have soared for home owners and landlords who are refinancing off historically cheap rates.

That is already starting to affect the market for buy-to-let (BTL) mortgage debt that was bundled up and sold to investors as bonds.

In the second quarter, “we noted a sharp 60 per cent increase in BTL arrears compared with 12 months prior”, said Ms Cristina Pagani, a director at Fitch Ratings. Although still low in absolute terms, it “could signal the start of performance deterioration in the sector”. 

In addition, there may be some weakness in so-called non-conforming mortgages, which are loans to home owners who do not meet the typical mortgage criteria from high-street banks. 

“We continue to expect an uptick in arrears in securitised pools, particularly in the non-conforming sector, where borrowers on floating rates are facing the burden of higher interest rates,” Ms Pagani said.

In the commercial real estate market, listed real estate investment trusts could also face higher borrowing rates if the pound weakens and swap rates rise, said Ms Sue Munden, a senior real estate analyst at Bloomberg Intelligence. 

Private-sector landlords are more vulnerable than their listed counterparts because they took on more leverage and, with prices falling, lenders may demand that they sell assets to recoup their loans.

“Forced private sales could push property prices down further and increase pressure on the higher levered listed companies,” she added.

Brexit sell-off

Rising rates have been hurting private equity firms that went on a shopping spree in Britain from 2017 through 2021, taking advantage of a so-called Brexit discount and cheap borrowings.

Household names from Morrisons to John Laing Infrastructure were bought up and loaded with leveraged debt. 

Many buyout firms failed to buy protection against interest rate hikes, meaning the cost of repaying the debt soared.

For example, Morrisons was unhedged until at least September 2022, according to Moody’s Investors Service, and though the grocer eventually put hedges in place for a portion of its debt, it was still on the hook for £375 million (S$630 million) in interest on a pro forma basis in its most recent fiscal year. 

“The leveraged loan corner of the market is where you see the more vulnerable parts of the economy and that’s where most of the concern is focused,” said Mr Peter Chatwell, head of global macro strategies trading at Mizuho, who was speaking generally about British companies.

Even beneficiaries of higher rates may soon start to suffer. Financial firms could be near a tipping point “where deposit costs start ramping and credit quality deteriorates”, said Mr Tim Craighead, a senior European equity strategist at Bloomberg Intelligence.

That is showing in insolvencies, which have been increasing since early 2021, according to data compiled by a government agency, as small businesses default on more loans, a trend that was expected to spread to medium-sized firms in the third quarter.

For those companies big enough to do so, raising money in euros and dollars can be more attractive than pounds because policy rates are 125 basis points higher in Britain than in the euro region. 

The move away from the British market can be seen in the leveraged loan market, which saw its first quarter this year without any sterling deals, and in refinancing activity. KKR-backed food group Upfield, for example, recently retired a sterling-denominated facility, replacing it with longer-term euro and dollar loans.

Even in Europe’s publicly syndicated debt market, the issuance of high-grade debt denominated in pounds from non-financial firms has remained at a trickle for several years, with borrowers instead piling in to the more liquid euro funding market.

The sterling corporate bond market has now shrunk in value by about a fifth since the end of 2021, according to one blue-chip debt index.

Hunt for cash

That has left some British firms exploring alternatives to deal with their debt stacks.

The country’s biggest pub chain Stonegate looked at selling 1,000 pubs and using the proceeds to repay some of its liabilities. After that process failed, it is now looking to move the pubs into a new entity and raise debt through that.

Look at a list of companies whose debt is trading at wide discounts to par, and you can see just how widespread the suffering has become across the economy.

Loans and bonds linked to the likes of the Canary Wharf financial centre, travel agency Saga and lender Metro Bank Holdings, which announced a capital raise and a haircut for some bond holders, are trading at distressed levels.

“The full impact of higher financing costs has not yet passed through to all corporate borrowers,” the BOE warned in its financial stability report this week.

Mr Sam Woodward, a restructuring partner at EY, said Britain’s businesses “are increasingly sensitive to the shifting credit landscape”, with the full effect of high rates and weak consumer demand yet to be seen.

He added that while 2023 has been relatively calm so far, “Christmas and early 2024 could be a different story”. BLOOMBERG