Borrowing costs

These businesses need to worry about rising borrowing costs

The era of cheap money is coming to an end, creating a potential problem for some companies that have accumulated a lot of debt.

Short-term borrowing costs have skyrocketed this year, in part because of the Federal Reserve’s recent rate hikes.

It’s a headache for businesses that need new loans, as well as businesses like Campbell Soup (CPB) and Colgate-Palmolive (CL) who have contracted variable rate debt, where interest charges rise as rates rise.

Interest on this debt is often tied to three-month LIBOR, a benchmark lending rate that has doubled in the past year. It recently hit the highest levels in almost a decade.

“The rise in LIBOR is really biting the private sector,” said David Kotok, founder and chief investment officer at Cumberland Associates. “The free ride of the credit system is over. ”

Wall Street appears to be punishing companies with high levels of variable rate debt.

Shares of S&P 500 companies with at least 5% of their debt in floating rate bonds fell 4% in the first quarter, according to a Goldman Sachs study released Monday. This exceeds the 1% drop in the S&P 500.

The group of 50 stocks, which excludes highly leveraged financials, real estate and telecommunications companies, is trading at a valuation 10% lower than the median S&P 500 stock, according to the report.

short-term loan jumps graph

Related: Problem With Rising Rates: Businesses Got Into Debt

Which companies are nervously watching the rising costs of borrowing? Stanley Black & Decker (SWJ), Campbell Soup and Colgate-Palmolive all have at least 20% of their total debt in floating rate bonds, according to Goldman Sachs. Other large S&P 500 companies with relatively high levels of floating rate debt include General Electric (GE), Conagra (CAG) and Textron (SMS).

“These stocks should struggle if borrowing costs continue to rise,” Ben Snider, analyst at Goldman Sachs, wrote in the report. He noted that the stock prices of these companies “reflected” fluctuations in short-term borrowing costs.

It’s not that Wall Street is worried that these companies won’t be able to repay their debt. This is because their interest charges are rising from historically low levels, reducing overall profits.

“The backdrop of high corporate debt and tighter financial conditions prompts us to continue to recommend holding stocks with strong balance sheets,” Snider wrote.

Companies incur interest rate sensitive debt because they usually offer more attractive terms than fixed terms.

“It’s cheaper. It’s a compromise a lot of companies make,” Kotok said.

Heavily indebted companies are also adapting to significant changes in the corporate tax code. The new law reduces the ability of businesses to deduct interest payments from their tax bill.

But if the rapid rise in borrowing costs reverses, investors could conclude that these stocks have been unfairly punished, setting them up for a rally.

Related: Tesla Has A Problem. Maybe a big deal

Goldman noted that the rise in LIBOR was due in part to the Federal Reserve. This makes sense because the Fed has steadily raised short-term rates as a sign of confidence in the economic recovery.

However, LIBOR climbed well above the rates set by the Fed.

Goldman blamed this on “temporary” factors, including changes in supply and demand caused by the new tax law and increased federal government borrowing.

“We believe this should stabilize, but at higher levels than in recent years,” said Rick Rieder, BlackRock’s director of fixed income investments.

American businesses took on a ton of debt during the economic recovery. Excluding the heavily indebted financial sector, corporate debt to GDP reached a record level in the third quarter of 2017, according to research firm Informa Financial Intelligence.

The S&P 500 company’s median net leverage ratio reached an all-time high, Goldman Sachs said.

corporate debt GDP

The good news is that businesses are raising tons of money right now, in part thanks to the tax law. This gives them a lot of extra money to cover the higher interest charges and pay off the debt.

Financial regulators are watching the space closely. Two measures of corporate debt studied by the Treasury Department’s office of financial research have been flashing red since early 2016, indicating potential “high” vulnerability.

Federal Reserve Chairman Jerome Powell said last month that corporate debt levels had risen, but default rates were “very low.”

“You see relatively high borrowing levels, but nothing that suggests… serious risk,” Powell said.

CNNMoney (New York) First published on April 3, 2018: 12:59 p.m. ET