Pet products retailer Petco (WOOF) borrowed $1.7 billion two years ago at an interest rate of about 3.5%. Now its interest rate is close to 9%.

Petco's interest costs soared to nearly a quarter of its free cash flow in the second quarter of this year. When Petco borrowed the money in early 2021, interest costs were less than 5% of cash flow.

Now, executives say reducing that burden is a top priority for the company. Petco Chairman Ronald Coughlin said on the company's August earnings call that debt reduction was one of Petco's three key capital allocation initiatives.

This is not Petco's problem alone. During the coronavirus pandemic, many companies had borrowed money at ultra-low interest rates through so-called leveraged loans. The debt is often used to fund private-equity buyouts or borrowed by companies with low credit ratings, with interest rates adjusted to the Fed's recent rate hikes.

Now, interest costs in this $1.7 trillion debt market are becoming unbearable for these companies, and Fed officials are predicting that short-term rates will remain high for some time.

Nearly $270 billion of leveraged loans have poor credit and could be at risk of default, according to ratings firm Fitch. As the US Federal Reserve has raised interest rates, credit conditions have deteriorated and are beginning to show signs of stress not seen since the outbreak of COVID-19. Excluding a surge in 2020, defaults over the past 12 months have been the highest since 2014.

The pressure comes at a time when leveraged loan funds are doing well. Investors had worried that rising rates would hurt risky borrowers, especially if they triggered a recession. But the strength of the U.S. economy has helped borrowers weather higher interest costs, while the plunge in fixed-rate, low-interest bonds has underscored the advantages of floating rate debt.

The gains from leveraged loans could easily be wiped out if the Fed's tightening moves wreaking some havoc on the U.S. economy and triggering a wave of defaults, says James St. Aubin, chief investment officer at Sierra Mutual Funds. Sierra holds floating-rate debt in its Tactical All Asset Fund, which uses an algorithmic model to buy and sell assets based on their performance.

"The asset I'm most worried about is bank loans," he says.

Apparel company Hanesbrands (HBI) has nearly $1.9 billion outstanding on two bank loans, with interest payments ranging from 7.2% to 8.9%. Chief Financial Officer Scott Lewis said in August that the company was working to improve leverage, or the ratio of debt to earnings, and to lower interest costs by using "all of our free cash flow to pay down reduced debt."

The company has made progress, paying down $100 million in debt in the first half and plans to pay down another $300 million in the second half. But cash flow has exceeded interest expense in only two of the last six reported quarters. In the most recent quarter, interest expense of $75 million almost completely ate up free cash flow of $78 million.

Standard & Poor's cut Hanesbrands' rating to B+ from BB- last month. Moody's cut Petco's rating from B1 to B2 in June, further lowering it in speculative grade.

In a sign of hope for investors and companies, chief financial officers and Wall Street analysts are increasingly confident that the economy is emerging from recession. In their view, the resilience of the labor market has helped keep consumer spending healthy, which can drive corporate revenue growth. The cash can be used to pay off high-interest debt.

"So far, borrowers have done a good job managing the increased interest costs because the economy is in better shape than many expected at the beginning of the year," said Hussein Adatia, who manages a portfolio of distressed corporate debt at Westwood in Dallas. 'The number one risk to leveraged loans is a sharp economic slowdown,' he said.

This will create more challenges for issuers such as Hanesbrands or Petco. Americans are already buying fewer pets, and Hanesbrands recently announced it was selling its Champion business after an activist investor opposed management.

According to the Fed's senior loan officer survey, banks are becoming more stringent about who they lend to, making it harder for companies with lower ratings to refinance. Fitch expects about $61 billion of those loans to default over the next two years, with the "vast majority" expected to occur by the end of 2023.

Some investors worry that the tightening of lending standards has come too late. Years of ultra-low interest rates have left investors hungry for yield and offered favorable terms to borrowers.

Adatia said that historically, creditors have recovered about two-thirds of the initial loan during a default, but he expects that share to be much lower now.

"The overall quality of loan documents is very bad right now," he said. "This is the product of 15 years."