A woman in a face exits Le Chateau at the Guildford Town Centre in Surrey, B.C., on Dec. 4, 2020, as the clothing chain was going out of business. In Canada, the number of business insolvencies rose by 37 per cent in the second quarter of this year compared with the prior year, says the Office of the Superintendent of Bankruptcy.Marissa Tiel/The Canadian Press
A surge in commercial bankruptcies is gaining speed in Canada and the U.S., a sign that tightening credit and rate hikes are starting to weigh on big business.
After binging on cheap credit through the first two years of the pandemic, the corporate sector is facing an increasingly challenging borrowing environment.
Corporate borrowers are dealing with interest rates at their highest levels in a generation. And U.S. banks have recently stiffened lending standards at a pace consistent with past recessions. Canada’s big banks announced this week that they set aside billions of dollars in their fiscal third quarter to cover risky loans.
“Reality is setting in,” said Brian Madden, chief investment officer of First Avenue Investment Counsel in Toronto. “The free money stopped flying around and we’re getting back to a more normal environment where bad businesses fail.”
In the year up to the end of July, more than 400 U.S. corporations filed for bankruptcy – more than the total for all of 2022, S&P Global Market Intelligence reported earlier this month.
In Canada, the number of business insolvencies rose by 37 per cent in the second quarter compared with the prior year, according to the Office of the Superintendent of Bankruptcy.
Few would be shocked if a sustained wave of corporate bankruptcies were to follow. Higher-for-longer interest rates have the potential to push many weak borrowers with high debt burdens over the edge. Just how well many of them have withstood the pressure this long is arguably the bigger surprise.
The immunity of corporations to high interest rates has been one of the economic curiosities of the moment.
When central banks jacked policy rates to levels not seen in more than 20 years, one may have reasonably expected the corporate sector to suffer mightily. That didn’t happen. Instead, earnings went up, business failures stayed low and credit issues were minimal.
That resilience has helped keep stock markets afloat over the last year-and-a-half. The S&P 500 index is actually up since the U.S. Federal Reserve began hiking rates in March, 2022. The S&P/TSX Composite Index, meanwhile, is down by a negligible 4 per cent since the Bank of Canada started its tightening campaign.
Why didn’t corporate profits buckle? Shouldn’t the soaring cost of servicing debt flow right to the bottom line? Not if you lock into rates when they are ultralow, which is precisely what U.S. companies did before the hikes started.
Nearly half of all debt on the books of S&P 500 companies is set to mature after 2030, according to a recent Goldman Sachs report. It doesn’t hurt that the substantial cash built up by many companies through the pandemic is earning a tidy 5-per-cent yield in the money market.
This may have extended the traditional cycle that sees higher rates and tightening lending standards translate to heavy corporate defaults, said James Hodgins, an analyst at Stifel Nicolaus Canada. But only temporarily.
“A nasty default cycle appears baked in,” Mr. Hodgins wrote in a recent note. “Our view is that this self-reinforcing credit crunch will spill over to equities in the coming months, particularly for companies with highly-levered unhealthy balance sheets, and immediate financing needs.”
This is the kind of thing the bond market tends to sniff out well in advance. But, as of yet, nothing is flashing red.
When concerns over business failures and defaults come to the fore, the difference between the yield on junk bonds compared with U.S. Treasuries tends to widen.
That metric currently sits at about 3.9 per cent, as measured by the ICE BofA US High Yield Index Option-Adjusted Spread. That’s well below the average spread of 5.4 per cent going back to 1997.
The bond market does not appear the slight bit concerned. One theory as to why, is that much of the lowest-quality debt resides in private markets and shadow banking rather than public markets.
“That doesn’t mean it can’t cause economic pain,” Mr. Madden said. “It just means we can’t easily see it coming.”