What happened

Shares of Carnival (CCL 0.88%) (CUK 1.11%) fell 6.3% this week compared to where they closed last Friday, according to data provided by S&P Global Market Intelligence, as concerns over economic woes took the helm of the cruise ship operator.

The tempest-tossed stock was buffeted this week by the prospects the Federal Reserve would continue its aggressive inflation-fighting stance and continue raising interest rates, a move that would make the cost of borrowing much more expensive for Carnival.

Four people on the deck of a cruise ship.

Image source: Getty Images.

So what

In a bid to stay afloat during the lockdown portion of the pandemic, Carnival and cruise operator peers Norwegian Cruise Line Holdings and Royal Caribbean Cruises took on a lot of debt. The cruise lines still had substantial expenses, such as ship maintenance and crew pay, and they had no money coming in.

Norwegian and Royal Caribbean have practically doubled the amount of long-term debt they carry on their balance sheets compared to before the pandemic to $12 billion and $18 billion, respectively. Carnival's nearly quadrupled to $35 billion. 

A Federal Reserve intent on ratcheting interest rates higher is going to weigh heavily on the world's largest cruise operator, especially because it and the others are still not operating at 100% capacity, thus limiting their revenue.

Now what

As my colleague Rich Smith recently pointed out, "for every 1% that interest rates rise, Carnival needs to earn $196 million more per year just to break even."

It faces additional rate risk next year as global financial institutions transition from U.S. dollar LIBOR, or the London Interbank Offered Rate for setting interest rates, to SOFR, the Secured Overnight Financing Rate. The former is based on forward-looking estimates to determine rates, the latter is backward-looking based on the cost of borrowing cash overnight collateralized by U.S. Treasuries. 

LIBOR will disappear on June 23, 2023, and will be replaced by SOFR, which is creating a lot of uncertainty over how interest rates will be affected, not just with Carnival, but businesses generally. A lot of Carnival's debt is variable-rate and would be impacted by how rates are set. What the cost is to Carnival will depend on how much the Fed raises rates to combat inflation.

Fortunately, there remains substantial demand for taking cruises and Carnival reports its bookings were "nearly double the level" for the same day in 2019 after it removed COVID-19 screening requirements and announced unvaccinated passengers can now sail.