Corporate Interest Expenses Are Expected to Increase Further

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In recent years, the Federal Reserve tightened monetary policy at an unprecedentedly rapid pace to quell post-pandemic inflation. Since March 2022, the target federal funds rate—the Fed’s preferred policy lever—has increased 525 basis points. In response, market interest rates have broadly risen across the economy, leaving businesses’ borrowing costs higher than levels that prevailed before the pandemic. High borrowing costs can discourage businesses from future investment and may pose risks to weak firms with limited earnings.

Firms may be better equipped to weather higher borrowing costs if they are not already highly leveraged. Although non-financial firms issued a large amount of debt during the pandemic, their leverage has declined to near pre-pandemic levels. Chart 1 shows that net leverage ratios—defined as total debt less cash holdings divided by earnings before interest, taxes, depreciation, and amortization (EBITDA)—rose sharply during the pandemic, when earnings declined and debt issuance soared.^_ Since then, however, corporate leverage has declined as massive fiscal stimulus helped shore up firms’ balance sheets. More generally, Chart 1 shows that leverage tends to rise during recessions and decline in economic expansions, consistent with its current behavior. Notably, net leverage ratios have declined across the distribution in recent years, unlike the recovery in the early 2000s, when some firms saw significant leverage increases.

Chart 1: Net leverage ratios for non-financial firms have returned to pre-pandemic levels

Although leverage and earnings have improved since the depths of the pandemic, firms have faced higher debt servicing costs as the Federal Reserve has tightened monetary policy. Chart 2 shows the distribution of interest coverage ratios (ICRs)—defined as EBITDA divided by interest expenses—at non-financial firms since 1999.^_ Higher values indicate firms are better positioned to meet their debt obligations. The median corporate ICR declined sharply in 2020 amid rapidly deteriorating economic conditions that delivered a sudden blow to business operations. However, ICRs began to recover in 2021:Q1 before peaking in 2022:Q3, reflecting rising earnings and the low interest rates that prevailed at the time. As the Federal Reserve started tightening monetary policy more recently, interest payments on debt increased, and ICRs have declined once again. In addition, the distribution has narrowed, with ICRs in the top quartile sliding toward their pre-pandemic levels.

Chart 2: Interest rate hikes have lowered interest coverage ratios

Although debt servicing costs have already increased, the Federal Reserve’s recent interest rate hikes are likely to continue to affect corporate debt in coming years. Although firms with floating-rate debt have already experienced the effect of higher interest rates, many firms issued low, fixed-rate debt during the pandemic and have not yet needed to refinance. When their debt matures, these firms, too, will face higher interest rates. To assess refinancing risks, we decompose corporate debt maturing in the next few years into fixed- and floating-rate instruments in Chart 3.^_ Consistent with increased debt issuance during the pandemic, we find that fixed-rate corporate debt (green bars) will increasingly mature over the next three years and will likely need to be refinanced at higher rates.^_

Chart 3: Interest payments may increase further, as a large amount of fixed-rate debt is expected to mature in the next few years

Making debt more expensive is an intended consequence of tightening monetary policy to contain inflation. Although the leverage ratio for non-financial firms remains at its pre-pandemic level, rapid increases in the federal funds rate have increased corporations’ interest payments. More importantly, the full effect of the Federal Reserve’s recent interest rate hikes on corporate bonds is likely yet to unfold: a large amount of fixed-rate debt will mature in the next few years, and firms may need to refinance some of this debt at a much higher interest rate. However, most firms have healthy interest coverage ratios, suggesting they can likely weather higher debt servicing costs as long as their earnings remain stable.