Hidden in Plain Sight:  Cumulative Impact of Interest Rate Hikes for Borrowers

September 21, 2022  |  By Michael Gaul  |  3 Minute Read

The Federal Reserve, in its ongoing effort to combat inflationary pressures, recently authorized its fifth increase of the central bank’s benchmark lending rate since the beginning of 2022.  In addition, the Fed projected an aggressive monetary policy going forward, signaling even higher rates to come for an extended period of time.  All told, the Fed has approved 300 bps of interest rate hikes, just in the most recent six months of 2022, while it attempts to simultaneously balance tempering demand for goods and services, while risking future job growth and potentially pushing the U.S. economy into a recession.   

For the average consumer, these Fed actions have an immediate and direct impact as the higher Fed Funds rates trickle down into elevated credit card, automotive, and housing borrowing costs.  The average 30-year mortgage rate has increased to above 6% — for the first time since 2008 – translating into monthly mortgage payments increasing by approximately $500 per month as compared to January 2022 mortgage rates.

The quantitative impact for corporate borrowers may not be as linear, but the nuanced, cumulative impact may be even more significant – both in terms of increased debt service requirements as well as reduced operating liquidity required for corporate growth initiatives.  Leveraged borrowers can easily recognize the higher interest rates on their variable rate loans, but the “hidden” impact potentially masks other challenges, namely the company’s ability to comply with its financial borrowing covenants and increased goods and service costs as vendors raise prices to combat their own, increased debt service requirements.

2022 Increases in Borrowing Rates

The table below illustrates the meteoric 2022 YTD change in the average Secured Overnight Financing Rate (“SOFR”) and the effective Federal Funds Rate (defined as a volume-weighted median of overnight federal funds transactions).  Each respective borrowing rate has increased roughly 200 bps.

Beyond the interest rate increases to date, the Federal Reserve has provided guidance they would further increase rates another 100-150 bps by the end of 2022, with higher rates in 2023 and beyond than previously forecasted.  Additionally, central banks around the world have followed suit with the Federal Reserve, exercising aggressive rate hikes year to date and forecasting further rate increases in a coordinated effort to realign global supply and demand curves.

Potential Hidden Impacts of Rate Increases

Reports of the inflationary impact of recent interruptions in global supply chains are well documented.  Inability to procure critical goods and a lack of visibility as to when those goods will be available have resulted in the highest domestic inflation in the last forty years.  Increased borrowing costs – via higher interest rates – potentially add another log to this financial fire.  Assuming suppliers follow tradition and “pass on” these higher costs to their customers, companies can expect to pay more for goods as the increased borrowing rates make their way through the procurement channel.

Therefore, companies are likely to experience reduced working capital as they are forced to pay more for goods and services due to suppliers passing on these increased borrowing costs.  While this abstract concept is widely recognized by experienced finance professionals, a company’s inventory accounting methodology can mask the near-term impact of rising inventory costs.  For companies utilizing weighted-average or FIFO inventory accounting methods, the adverse liquidity and profitability impacts will not be immediately recognized as the increased “true” costs are not identified until a later accounting period.  Depending on a particular entity’s inventory conversion cycle as compared to its vendor payment terms, companies will potentially feel the near-term liquidity constraints long before the impact of higher costs (from increased interest rates) are recognized on the financial statements.   

While the detrimental, monetary impact of higher interest rates is initially experienced within a company’s liquidity management and financial statements, a borrower’s compliance with its financial lending covenants will likely be negatively affected as well.  As illustrated in the chart below, any financial covenant that tests a borrower’s profitability – on a standalone basis or within a financial statement ratio – will certainly be reduced as the borrower is required to allocate additionally liquidity for debt service requirements.

In the chart below, a hypothetical scenario is presented to illustrate the specific impact of increased borrowing rates on a customary Fixed Charge Coverage Ratio (FCCR).  The chart presents the recent historical increases of the Base Lending rate from July 2021 to September 2022, as well as the current forecast for the next two years.  Using those Base Lending rates, the chart estimates the FCCR trend for two entities: 

• FCCR A – a company with consistent working capital requirements with the exception of the impact of higher borrowing costs 
• FCCR B – a company experiencing a 20% increase in its funded revolver due to increased inventory costs and the impact of higher borrowing costs

Both scenarios below illustrate the potential, destructive impact of higher borrowing costs on an entity’s ability to remain in compliance with customary FCCR covenants.  If companies are unable or unwilling to increase unit pricing and/or reduce other expense categories commensurate with the increases in debt service requirements, borrowers will likely face significant challenges remaining in compliance with their financial covenants in the years to come.         

While the financial challenges highlighted above are having substantial impact to companies’ liquidity now and in the years to come, Phoenix Management is uniquely positioned to assist our clients in assessing the current environment and developing a financial plan mitigating the operating risks of these higher costs.  We have worked with clients to aggressively implement targeted price increases and execute organizational expense reviews to maintain healthy operating margins and forge a path for stable growth going forward.

Contact Phoenix to learn more about monetary policy and liquidity management issues.

Borrowing Rates Federal Reserve Interest Rates