Turbulent waters may signal a wave of defaults on the horizon

Tue 26 Apr 2022

On the 23rd March 2020, the United Kingdom entered its first official lockdown in an attempt to limit the spread of the COVID-19 virus. The initial uncertainty was catastrophic for the economy and many UK businesses were forced to cease trading as revenues plummeted to zero almost overnight. Offices were abandoned, restaurants and pubs deserted and schools were emptied across the country. The economy was kept afloat by both massive monetary and fiscal stimulus and many businesses enjoyed grants, loans at record low interest rates and sizeable tax cuts.

Over the last year we have seen a rebound in economic activity as we have learnt to live with the virus and lockdown restrictions have been eased. Much of the fiscal support provided to businesses in the wake of the pandemic has now been withdrawn and society appears to be returning to normal. However, there is a clear distinction that can be made between the economic environment in 2020 and now: the presence of inflation.

Despite the rebound, economic conditions are far from ideal. Supply chain disruption, skyrocketing raw materials prices and the war in Ukraine have all contributed to a surging rate of inflation that is now reaching levels not seen for the last 40 years in the Western world. As the Bank of England scrambles to address the issue, it has so far opted for interest rates as it’s weapon of choice, raising rates to 0.75% in March. Markets currently project six more hikes this year. This will bring rates to 2.25%, the highest level since the beginning of the Global Financial Crisis in 2008.

Rising interest rates increase the cost of borrowing and pose a significant challenge for UK companies. Over a decade of quantitative easing (QE) has made debt financing a cheap method of fuelling future company growth and an increasing proportion of UK businesses have aimed to improve their firm’s capital structure by reducing equity financing and increasing debt. Additionally, near-zero bond yields have made paying dividends much easier. Instead of paying dividends through earnings, CFOs have opted to borrow at record-low interest rates to further boost dividend payments. Companies now find themselves with rising debt obligations and reduced profit margins as inflation pushes up raw materials prices. As such, less financially stable businesses will find it significantly more difficult to make their agreed debt payments on time. So how are UK companies poised to deal with this paradigm shift? Are we likely to see more companies failing to pay their debts on time?

Significant levels of debt were taken on by UK companies during the pandemic. In 2020 over 12% of companies in the FTSE All-Share were borrowing over twice as much funding as they owned. Whilst the percentage of the most indebted companies has since fallen, over the last twelve months, it is clear that companies are once again piling on additional debt. However, it is apparent that smaller companies are experiencing the burden of this challenging business environment more than their larger counterparts. In 2021, a much larger proportion of small and medium-sized businesses had noteworthy levels of debt relative to their reported earnings. This method of business financing has had little consequence over the last decade, as borrowing has been cheap. Nevertheless, as borrowing becomes an increasingly costly strategy, business revenues and growth prospects are unlikely to keep up. This paints a rather bleak picture for the small business owner, but replicates the expectations of main lenders surveyed by the Bank of England, who anticipate a significant uptick in the number of defaults (where companies fail to make their agreed debt payments on time) in both smaller and medium-sized corporations.

In contrast, data from private sector companies appears to indicate that debt levels have improved significantly since the initial onslaught of the pandemic. Businesses have been able to reduce their debt loads and by the end of 2021 were sitting at a similar relative levels to those seen in 2016. But this is only a surface view. In fact, two sectors have significantly ramped up their debt funding in the last five years: energy and technology. With crude oil prices at current levels, this increased leverage is unlikely to pose a significant issue. However, as commodity prices continue to climb, the potential for a period of demand destruction and subsequent recession remains a sizeable risk for the sector. Technology companies are typically growth oriented and the rising risk of a stagflationary environment in conjunction with rising interest rates over the next 12 months will prove a challenge for many companies that have only experienced an environment that facilitates growth.

Debt levels somewhat represent a parabolic risk: they are only a concern once businesses can no longer afford to finance the debt. The reality is that debt financing is more expensive than it was five years ago and is likely to continue to increase over the mid-term as central banks grapple with a problem that they are ill-equipped to face.

Economic strains are likely to have a disproportionate impact on smaller companies, and we anticipate that default rates of smaller to medium-sized corporations will rise over the next twelve months. However, at the end of the day, it boils down to quality. Companies with resilient balance sheets and little leverage are more likely to weather the storm ahead. Those that have aggressively targeted growth, be it through equity or debt financing, will probably become more acquainted with the downside risks of this strategy as we face a new economic paradigm of lower growth and higher rates.