By Chiara Elisei

LONDON (Reuters) – U.S. and European small and medium-sized (SME) firms may be next to feel the pain of rapid interest rate rises, with analysts and investors warily watching for the impact of tighter credit conditions exacerbated by recent banking turmoil.

Unlike large companies that typically issue fixed-rate debt and have little exposure to short-term rate fluctuations, SMEs rely on direct bank funding, so the effect is felt in real time.

And while the exposure of SMEs to higher rates and the potential for default may have so far gone largely under the investor radar, especially since bigger companies have held up fairly well, some are on the lookout for any signs of strain.

“As liquidity drains, what seems like idiosyncratic little issues start to pop up,” said Brett Lewthwaite, global head of fixed income at Macquarie Asset Management.

Ratings agency S&P expects U.S. and European default rates to reach 3.75% and 3.25% respectively by September, more than double the 1.6% and 1.4% the same month last year.

SMEs are critical to economies on both sides of the Atlantic, with the European Commission estimating they employ around 100 million people in the EU and account for more than half of the bloc’s economic output.

The European Central Bank’s latest Bank Lending Survey shows euro area banks reported a substantial tightening of credit standards for loans or credit lines to businesses in the fourth quarter of 2022, before the impact of this month’s bank stress.

That was the largest change registered by the survey since the bloc’s 2011 debt crisis.

The European Banking Authority (EBA) was not immediately available for comment.

In the U.S. the average rate that small businesses pay on bank loans rose from around 5% to 7.6% in 2022, and is likely to hit about 9.5% by mid-year, Jefferies analysts estimate.

Analysts note the latest U.S. Senior Loan Officer survey pointed to “significantly tighter” credit conditions for SMEs.

“In the current deteriorating environment, big is beautiful and smaller companies are going to feel the most pressure from interest and energy costs, broken supply chains and a lower real disposable income from households,” said Generali Investments’ senior credit strategist Elisa Belgacem.

DISTRESS RISES

The iTraxx Europe Crossover index, measuring the cost of insuring exposure to a basket of junk-rated corporate bonds, has risen recently but is well below peaks seen during the COVID crisis.

Guy Miller, chief market strategist at Zurich Insurance Group, said that even with sharp rate rises, investor focus has been on companies that are in good shape and well positioned to handle higher borrowing costs.

“But when you think of all the smaller and medium-sized companies in Europe and U.S. that are dependent on bank financing, revolvers (a type of bank facility), and often even on owner financing, funding is becoming a major issue,” he said.

British SMEs, hurt by weak growth, double digit inflation and rising Bank of England rates, are seen as particularly vulnerable.

BoE’s inflation fight continues https://www.reuters.com/graphics/BRITAIN-BOE/mopakwyzqpa/chart.png

UK corporate distress levels accelerated in the quarter to February to their highest since June 2020, an index compiled by law firm Weil Gotshal & Manges shows.

European SME’s distress on the rise European SME’s distress on the rise https://www.reuters.com/graphics/GLOBAL-MARKETS/lgpdkjbwovo/chart.png

Another recent survey by Manx Financial Group showed that 22% of UK SMEs that needed external finance over the last two years were unable to get access due to the higher cost of funding, processing times, and lack of flexibility.

Manx Financial Group CEO Douglas Grant said while many SMEs had locked in rates for a fixed period, to limit exposure to further rate increases, others had not.

“Small businesses are counting on today’s rise in the base rate to be the peak, as the Bank of England predicts a steeper than anticipated fall in inflation, even following the unexpected rise we saw earlier this week.

In response to the most recent BoE rate increase, Federation of Small Businesses (FSB) National Chair Martin McTague said “inflation is exacting huge tolls on small firms, who are even more exposed to spiralling input costs than large businesses”.

“The Government needs to demonstrate that it is on the side of small businesses who are feeling stressed and under huge margin pressure,” McTague added.

HARD TIMES

Meanwhile the rate of small business loan approval at big U.S. banks meanwhile fell in February for nine straight months and business loan approvals at small banks has also fallen, said online financing platform for small businesses Biz2Credit.

Small U.S. banks have seen a $119 billion exodus in recent weeks as depositors took fright after the collapse of Silicon Valley Bank.

Biz2Credit CEO Rohit Arora said he expects it will now become even harder for small businesses to secure capital, with the biggest challenge that rates stay higher for some time.

“While it’s unlikely that rates will come down before next year, at least business owners will know this is the maximum they have to pay,” Arora said.

Nevertheless, as financing costs jump and become harder to access, the risk of a spike in default rates is becoming increasingly tangible, analysts said.

“The weak hands are starting to be revealed,” said Macquarie’s Lewthwaite.

(Reporting by Chiara Elisei; Additional reporting by Dhara Ranasinghe; Graphics by Vincent Flasseur; Editing by Dhara Ranasinghe and Alexander Smith)

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