Rising rates are stressing out the riskiest companies

As the interest rates on government bonds rise, so do interest rates throughout the economy. That makes borrowing money more expensive for consumers, small businesses, and big corporations.

But those interest rates don’t all rise at the same pace. Over the last few months, rates on a particular kind of corporate bond have been rising at an especially fast pace: bonds issued by companies that investors see as relatively risky. Those are the kind of bonds that already pay a lot of interest.

Different kinds of corporate bonds work kind of like the different loans an individual might take out. There are investment grade corporate bonds, which are akin to mortgages, insofar as they’re considered relatively safe because the lender’s probably going to get its money back.

“Even if the homeowner can’t pay the mortgage back, the bank gets the house, and they’re able to get their money back in another way, so it’s low-risk from the bank’s perspective,” said Drew Pascarella, a professor of finance at Cornell University.

Then, you get into riskier kinds of credit — sort of like a subprime auto loan, or credit cards. If a borrower runs into trouble and stops making payments, the lender might not be made whole.

“Without that safety of the bank being able to, say, in a mortgage, reclaim the house itself, it’s a riskier proposition for a bank,” Pascarella said. “And with that additional risk comes additional interest rate.”

The corporate version of these risky loans is known as high-yield debt, sometimes known as junk bonds. Pascarella said the risk of default by companies that issue bonds of that type could come from a variety of factors: a company might struggle to change with the times. Think RadioShack or Toys R Us.

It might be really exposed to rising energy prices. Or, Pascarella said, it might simply have too much debt to begin with.

“And they can find themselves in a similar spot,” Pascarella said. “Not because the business is necessarily going downhill, but because the amount of money that they have to pay back is too much for what the operation can afford.”

Over the last few months, interest rates have been rising the most on the riskiest high-yield debt: corporate bonds with what are known as CCC ratings, which is one of the lowest credit scores a company can get.

Winnie Cisar, global head of strategy at CreditSights, said firms in that category include rental car companies, movie theaters, telecom companies, and several retailers.

“PetSmart, Michaels, Guitar Center — those are three big retailers in the CCC cohort currently,” she said.

Cisar said many of those companies are dealing with challenges unique to their own industries. But a common theme is that they’re all having trouble paying off their debt. And it’s getting even harder for them as rates rise.

“They’re highly sensitive to changes in the borrowing cost environment, because oftentimes that interest expense is a big chunk of their cash flow,” she said.

Stress in the corporate bond market can become a vicious cycle.

When a company has to pay more and more interest on its debt, it might have to cut back elsewhere, said Randy Vogel, head of fixed income with Wilmington Trust.

“The larger portion of your cash flow that’s going to pay off debt, the less you have to create new products, update machinery, things you would hope would have a benefit to cash flow in the future,” Vogel said.

As interest rates on riskier debt continue to rise, investors might not even want to buy those kinds of bonds anymore. Cornell’s Drew Pascarella said that could cause even bigger problems when companies have to raise money.

“If a company’s in need of money because they have an existing loan that’s coming due, or to make current payments to employees, or to suppliers — if you need money and you can’t borrow it, you’re in trouble,” he said.

Pascarella noted that if they can’t issue new bonds, some of them might go bankrupt.