THE BATTLE RAGES -
The Fed raises interest rates by .25%
Ben T. Nicholson
At a Glance
The Federal Reserve increased interest rates by .25%, with two additional interest rate increases projected over the next two meetings.
The increase in the cost of capital is having the effect of dropping a debt coverage ratio on an analyzed business from 1.25 to 1.08
Given the same scenario in an SBA loan structure, the debt service coverage ratio drops to 1.01, and if the latest rate increase is applied, it drops to 1.00.
There is an argument that the Fed (historically) wants interest rates to be consistently 200-basis points (2%) above inflation. If rates are below inflation, it is cheaper to borrow money and spend it, which alternatively drives more inflation. This is part of what got us where we are in the first place, and it is why we got an extra .25% increase in interest rates yesterday, with the likely addition of at least two more .25% increases in the next two policy meetings.
According to the chart above, as of December, after adjusting for inflation real interest rates are still -2.32%, which, according to history, means the Fed is still behind in getting ahead of inflation by a gap of over 4%. While they may slow the roll, so to speak, there is no indication the Fed is stopping its restrictive policy anytime soon. No doubt inflation is coming down (unless you eat a lot of eggs), and the recent increase will help, but unless they change their minds and the Fed settles for a tolerable 3% inflation, we still have a ways to go.
This leads us to the effect on businesses and their bank loans. One could argue the original conversation we started last summer about Stress Testing for Margin Compression During Economic Volatility is dated, but in reality, it is becoming even more important. Rates have continued to tick up, and are not stopping. The conversation continued as we took a business with an acquisition loan, both C&I and SBA 7(a), and stress-tested it through the lens of the Debt Service Coverage Ratio (DSCR) and showed results in Effects from an Applied Stress Test.
With yesterday's rate increase, our loan under a normal C&I structure that started with a DSCR of 1.25 is now at 1.08. The same loan under an SBA structure, which is now in double-digit interest rates, sits at 1.01. This means the annual debt service on a $2.2mm loan increased by 16.8% to an additional $52,000 coming straight out of operating cash flow. If the SBA loan were to be revised with yesterday's increase, the DSCR would be 1.0 with the business likely looking for cash to pay the loan from other sources.
As the cost of capital increases, lenders will naturally engage in rate sensitivity testing. However, it would be prudent for anyone dealing with optimizing a capital structure to do so as well, including M&A advisors, SBDC consultants developing business plans, professional services advisors, anyone modeling discounted cash flow, and business owners themselves. Otherwise, someone in the restructuring and distressed business space may unexpectedly end up showing up at the door.