In December 2023, the Bank of England examined the intricacies of household and corporate indebtedness and their implications for the UK's financial stability. Specifically, the resilience of lenders and borrowers emerges as a critical lens through which to understand the potential risks associated with high levels of debt. Against the backdrop of UK economic developments, including fluctuations in inflation, real incomes, and mortgage interest rates, the Bank expects both household and corporate debt to be under greater pressure, but resilient to sustained high interest rates.
This focus extends to the vulnerability of UK households, particularly in the realm of mortgage debt, where shifts in interest rates and debt-servicing costs pose substantial concerns. Simultaneously, attention is directed toward the corporate sector, assessing its overall resilience to economic headwinds and the nuanced vulnerabilities within specific industries.
Looking at household debt vulnerabilities, in recent years most mortgages have been taken out at a fixed interest rate. This has meant that repricing of debt for households will affect mortgagor households with a lag – when they refinance or move to a floating rate. For example, rates on a 75% loan to value mortgage fixed for five years were around 5.0% in October, and around 5.4% for 90% loan to value.
Around 55% of mortgage accounts have repriced since rates started to rise in late 2021. Furthermore, higher rates are expected to affect around 5 million households by 2026. The Bank of England estimates that, for the typical owner-occupier mortgagor rolling off a fixed rate between 2023 Q2 and the end of 2026, their monthly mortgage payments are expected to increase by around £240, or 39%. As these higher servicing rates of mortgage payments flow through to U.K. households, the average debt-servicing burden will increase:
Figure A
Source: William John Analytics, Bank of England, FCA Product Sales Data
In fact, the aggregate mortgage debt-servicing ratio is projected to rise from 6.8% in Q2 2023 to nearly 9% by end of 2026. Whilst substantial risk exists, household debt to income ratios have fallen, with only a moderate increase expected in households with high debt servicing burdens.
Furthermore, robust capital, regulation and lender forbearance measures are in place. The ability for borrowers to extend mortgage terms combined with these measures should ensure that mortgagors can ride the storm of the rise in servicing costs. However, the buy-to-let sector may face challenges, leading landlords to raise rents or sell properties.
Transitioning to an analysis of corporate debt, aggregate corporate debt relative to earnings has decreased, with the gross debt to earnings ratio at 276% in Q2 2023, down from 345% in 2020 Q4. Despite this aggregate resilience, however, vulnerabilities persist for specific firms or sectors, particularly those dependent on discretionary consumer spending or operating in energy-intensive markets.
Looking at interest coverage (ICR) analysis:
Figure B
Source: William John Analytics, Bank of England, S&P Capital IQ
The debt-weighted portion of medium and large companies with ICRs below 2.5 will increase from 28% in 2022 to 37% by the end of 2023. However, this is lower than anticipated and significantly below the early 2000s peak of 65%, partly due to robust earnings growth and a decreased market-implied Bank Rate path since July.
Some sectors, like wholesale trade and real estate, face rising debt-weighted shares of firms with low ICRs, indicating increased vulnerability. However, these sectors constitute a small proportion of aggregate corporate debt.
While market-based finance has diversified funding sources, it introduces cyclicality risks. The share of debt from market-based finance has risen, making it susceptible to rapid changes in investor sentiment. Despite this, higher interest rates haven't affected all companies, with refinancing pressures expected to increase as fixed-rate debt matures.
For small and medium-sized enterprises (SMEs), debt-servicing pressures have risen, especially for those not using government-guaranteed loan schemes. The median SME debt-servicing ratio (DSR) remains stable, but the 75th percentile DSR has increased since 2022 Q3. SME arrears for commercial loans have risen moderately, reaching 1.3% in August 2023. Meanwhile, corporate insolvency rates have increased but remain low compared to historical averages, with the rise driven by very small firms with limited debts.
In summary, the Bank of England's recent analysis of UK household and corporate indebtedness emphasizes the resilience of lenders and borrowers in the face of potential risks associated with elevated debt levels. Anticipating increased pressure on both household and corporate debt, their report underscores overall resilience, particularly in response to sustained high-interest rates. Household debt vulnerabilities, particularly in mortgage debt, reveal concerns around the repricing of fixed-rate mortgages, mitigated by measures such as extended mortgage terms and robust capital regulations. In the corporate sector, despite an overall decrease in the gross debt to earnings ratio, vulnerabilities persist for specific firms or sectors. The interest coverage ratio analysis highlights increased debt-weighted portions with ICRs below 2.5, tempered by robust earnings growth. Market-based finance introduces cyclicality risks, and while higher interest rates have yet to impact all companies, concerns arise regarding increased refinancing pressures for fixed-rate debt. Challenges are observed in SMEs, with rising debt-servicing pressures, and vulnerabilities persist in the commercial real estate market. Despite these challenges, the UK banking system demonstrates resilience, providing reassurance amid the intricacies of indebtedness.
Any opinions expressed in this document are those of William John and are provided for information only. E&OE
