Interest rate hikes may be peaking in Europe, but consumers, businesses and governments who borrowed trillions of euros during the era of ultra-low financing costs are still in for a lot of pain.
Until the end of this decade, borrowers across the continent are facing repayment of a mountain of debt incurred when financing costs were much lower. Although the adjustment is painful in many places, including the US, it is especially shocking in Europe, where interest rates have been below zero for eight years. Many borrowers have delayed refinancing in the hope that rates will drop again. But with economies holding up better than expected, that seems increasingly unlikely.
Investors predict that the next few years will be marked by the defaults and the spending cuts, as more of the income of companies, households and governments goes to finance the debt. A clear indicator of the sea change to come is the difference between what governments and businesses around the world are currently paying in interest and the amount they would pay if they refinanced at current levels. Apart from a few months around the global financial crisis, the indicator has always been below zero. It is now hovering around an all-time high of 1.5 percentage points.
“If your bet was that the 2010s were the new normal where rates kept going down and you could always refinance, this is a really tough environment,” he exposes. Bloomberg Mark Bathgate, a former Goldman Sachs and BlueBay Asset Management investor who now runs his own advisory firm. “Europe’s credit problems could be much worse than in the US. There was a much better chance of a buildup of a excessive leverage“.
Milton Friedman first coined the idea of long and variable delays in monetary policy in the 1960s. Simply put, it is the uncertain amount of time before changes in monetary policy begin to affect the economy. While the price of assets such as government bonds often moves in anticipation of, or immediately after, a central bank decision, it takes time for rate changes to feed through to longer-term contracts and , therefore, to price fixing, labor markets and, finally, inflation.
For companies in Europe, many of which borrowed heavily during the pandemic, the great wall of refinancing it starts in 2025 and reaches its peak in 2026. High-yield companies in the Old Continent have more than 430,000 million euros of debt that matures in the second half of the decade, according to data compiled by Bloomberg. The jump will be from less than 15,000 million in 2024 to more than 80,000 million in 2025. In 2026 the peak will exceed 100,000 million.
“During the easy money boom years there wasn’t as much attention paid to what a high interest rate environment might mean,” says Danielle Poli, a portfolio manager at Oaktree Capital Management. “We still see tensions looming for some borrowers, especially those with more aggressive capital structures.”
Certainly, defaults among the riskiest companies are not expected to come close to the 13.4% rate recorded during the global financial crisis. Moody’s Investors Service expects the global default rate for companies rated ‘junk’ to exceed the historical average by the end of this year, before peaking at 4.7% in March 2024. In Europe, it is forecast to reach a maximum of 3.8% in the middle of next year.
For most companies, higher rates are more likely to cause lower capital spending, which in turn will hurt economic growth. Companies in Europe, the Middle East and Africa bought back bonds at the fastest pace since 2009 in the first five months of the year to trim leverage and reduce interest payments. Others have tried to lengthen the maturity of their existing debt. Although this is often sweetened with a coupon increase, it is cheaper than going to market and attracting new investors with a new debt issue.
Researchers at the Bank of England estimate that highly leveraged companies account for around 60% of the world’s corporate debt. United Kingdom, but only 5% of the cash. This means that these companies are more likely to cut investment or jobs to stay afloat.
According to Jochen Schönfelder, a senior partner at Boston Consulting Group in Cologne, Germany, companies may need to start raising funds to refinance their debt up to a year before it comes due, in case they need to find new lenders. Schönfelder has already seen how the german companies cut costs and says some are turning to private debt funds if they need quick money.
“Many expect some of Germany’s most important sectors, such as construction and automotive suppliers, to get worse,” says Schönfelder. “The big question is whether this will also extend to plant equipment, machinery, equipment suppliers and also how private consumption will be affected.”
The consumers will suffer above all through the increase in mortgage costs, and in many countries the rise in interest rates has not yet passed through to monthly payments. The effective interest rate on outstanding UK mortgage loans was below 3% at the end of June, according to the Bank of England, compared to 6.7% for the average for new two-year fixed products, according to data from Moneyfacts.
Sweden it can serve as a barometer of what awaits other countries. According to Finansinspektionen, new Swedish mortgage holders have seen their borrowing costs as a proportion of income double to 10% by 2022, the highest level in at least a decade. This has caused real estate prices to plummet, triggering a spate of insolvencies and debt relief requests among builders.
Problems for governments
Another potential pressure point for the continent is the fact that the peripheral economies, like Italy and Portugal, have a higher proportion of outstanding variable-rate mortgages. This “remains one of the main risks of a hard monetary policy landing, with the weakest economies suffering the most,” Bank of America analysts, including Claudio Irigoyen, wrote in a recent note to customers.
The rise in interest rates is already beginning to weigh on the finances of the state. Globally, states rated by Fitch Ratings will face some $2.3 trillion in interest in 2023, representing an increase of almost 50% for developed markets since 2020. For countries like the UK, where a quarter of public debt is linked to inflation, the burden is even greater. According to the latest public finance data, last month was the most expensive in terms of interest costs of all registered joules.
The burden on governments it is already reaching city councils and subnational public authorities. Many UK councils have put their long-term borrowing programs on hold in the hope that rates will come down. “Our advice is basically to sit by and don’t borrow long-term this year until inflation, bank interest rates and bond yields start to come down,” says David Whelan, managing director of Link Group, which advises British local authorities.
The problem is that they may have to wait a long time. Earlier this year, a series of bank failures led many to forecast that a further credit crunch and recession would lead to a sharp rate cut by the end of 2023. But economies proved more resilient than expected, making it likely that interest rates will stabilize. “How long we stay in this environment of higher cost of capital and tight monetary policy matters far more to borrowers” than where interest rates ultimately end up, concludes Amanda Lynam, head of BlackRock’s MacroCredit Research.
