Impact of Rising Rates on the Middle Market

The headlines are awash with news of interest rate increases as Fed Chairman Powell seeks to remove the proverbial punch bowl from the party, as the economy strengthens. While inflation has been subdued for many years, it could arise given the upsurge in the economy and investment.

Mortgages are more expensive for sure, and variable interest rate loans get repriced when prime moves up. Yet the absolute movement in rates has been rather tame, as the discount rate has gone from .75 as of 2011 to 2.25% as of a few weeks ago.

The discount rate is still very low from a historical standpoint. The rate of increases has accelerated with 5 moves of 25 basis points since December 2016, and that has the market concerned a bit.

Middle market companies with floating rate loans are paying more interest, yet many middle market loans are fixed rate instruments. These loans are fixed during the loan term, so there is no impact from rising rates.

Furthermore, certain middle market lending channels such as mezzanine debt, have actually transitioned to lower returns over the last several years. This is good news for borrowers who pay lower interest expense to their mezzanine lenders.

The increase in interest rates, has actually affected their returns negatively, as banks have become more aggressive and made it harder for mezzanine lenders to compete.

So the current increase in rates is occurring at a time when banks are emboldened, and is creating more credit in the system.

This will reach a point of equilibrium, where risk profiles become stretched, and the rate of bank lending will then moderate.Private debt funds price on a floating rate level as do BDC’s.

The rise in rates results in a higher interest expense for their borrowers. Assuming fixed overhead and loss ratios for assets under management, higher rates increases the yields of a debt fund making it a more attractive investment vehicles for investors.

In the middle market, borrowers have more options, at slightly higher pricing with more lender competition. The rise in rates may be felt most acutely by overleveraged middle market companies who find they are no longer able to deduct 100% of their interest expense on their taxes.

Interest rate policy has always been affected by fed goal steering as well as a response to major black swan events such as Y2K and the subprime crisis. The future path of interest rates will likely revert to this pattern, where rates will rise to tamp down animal spirits, but also provide insurance and mitigate against nasty unexpected surprises.