Time to Pay the Piper? A Look at the Prospective Cost of Capital
In the first two installments of this series, we made the point that the corporate cost of capital has nowhere to go but up. But what does this imply in the real world? We believe the implications are significant.
The Interest Rate Dilemma
Once upon a time, we enjoyed a period during which capital markets revolved around hoary ideas such as the term structure of interest rates and inflation. You were supposed to be able to make at least some money investing in bonds. Ignoring taxes, “real” (i.e., nominal yield, less inflation) returns on US government debt has averaged 2.25% over the last half-century.
RELATED: PART 2 – COST OF CAPITAL | IMPLICATIONS FOR THE FUTURE
Today, the real return appears to be negative. For investors to do well prospectively, today’s financial asset prices must fall. Should anyone care? If you wanted to reduce inequality, we would argue that such a step is necessary. Otherwise, today’s “haves” will simply remain in place, and the “investor wannabes” will have a very hard time scaling the wealth ladder. We also believe rational players should care because the current situation is an arbitrary creation of the government, and the embedded rates and prices will probably lead to different corporate decisions than if such prices had developed through true market forces.
In the current era of negative real interest rates, the forces of creative destruction are neutered. Overleveraged borrowers – so called “zombie companies” – can refinance or “amend and extend” as investors reaching for yield ignore credit quality (we noted in our last entry that CCC bonds yield a paltry 7%). The companies are being permitted to limp along, funneling most (if not all) of their resources to debt service. Traditionally, these borrowers would be properly recapitalized, allowing them to resume growth-oriented capital investments instead of interest expense.
There are myriad theories as to why this state of affairs in the bond market has come to be. But at the end of the day, we think it boils down to too much liquidity chasing too few financial assets. And the (likely inflationary) Biden stimulus programs could foster an environment of continuing negative real rates, even if the proposed tax increases go through. Nominal rates may increase in an inflationary period, but real rates may remain below levels of inflation. For example, we are hearing talk of 3% “headline” inflation (which assumes that the current inflationary spike abates quickly), but we hear not a peep regarding the prospect of 3%+ government bond rates.
Momentum is a concept in physics which can be interpreted to mean that an object will continue along its path until it doesn’t. We think this may be describe the financial world in which we currently find ourselves.
Interest Rates and Corporate Investment Opportunities
We have previously written about the disturbing corporate trend to engage in massive stock buyback programs, rather than invest in productive capital expenditures and other projects. [RELATED: PART 1 – COST OF CAPITAL | PAST, PRESENT AND FUTURE?]
Does this mean stock buybacks occur because of poor investment opportunities? Maybe. Do ESG policies have the potential to narrow investment choices further? Also a definite maybe, as evidenced by US Steel’s recent decision to cancel over $1 billion of refurbishment capex and to close plants.
COVID, ESG and a host of other factors created a perfect storm for certain capital-intensive industries such as oil & gas and real estate. The fact that not as much capital is being directed into these sectors as before also contributes to the wave of unused investment funds sloshing around. Will these investment gaps be filled by money needed to finance clean and green energy and building projects?
Certainly, (almost) anything is possible. But we would think there will be a very long wait until public infrastructure spending (on real infrastructure, not social programs), e-vehicle rollouts and a complete redo of our energy supply all occur. Or a really massive tax hike is instituted.
Washington Can Change the Dynamic, But It Probably Won’t Want To
One of the largest single reasons for the huge pile of available capital is the Quantitative Easing (QE) programs put in place after the Great Recession financial crisis. The Fed successfully inflated asset prices, and stabilized the crisis, but has not removed the excess liquidity from the system. Such an action would be anti-stimulative and likely exactly the opposite of the economic prod that the Biden Administration says it wants to provide.
Having said that, there was an interesting byplay in May between Jerome Powell and Janet Yellin regarding hypothetical government responses to higher inflation and other scenarios. Our takeaway is that this is a highly politically-charged issue for the Fed, and it will only have a mandate to cleanse the system of excess liquidity if inflation really gets going.
As indicated above, the Biden Administration itches to reduce wealth inequality. Although it could achieve a lot of this through a reverse QE program, our bet is that it will try to lower inequality through the Tax Code. But we wouldn’t rule out QE in reverse – particularly if the economy is fully back on its feet by 2022. The Fed has indicated it won’t take action until inflation is already above a 2% target for a sustained period, and it will be interesting to see if, when and how they pull the trigger in an attempt to combat inflation.
Investors Can Always Go on Strike
Finally, investors are being asked to take a lot of risk for what appears to be little return. We think this is most pronounced in areas such as CCC bonds, where the market pricing is assuming virtually no defaults. As an aside, Professor Ed Altman of NYU has spent a lifetime analyzing default rates, and has shown that CCC bonds suffer default almost 50% of the time within five years1. Pricing in other asset classes may seem to be a bit more rational, but we would argue that they are virtually all overpriced. If investors pull back from the market en masse, we think pricing would eventually correct.
For the cynically-minded among us, there is another investor-driven scenario. Markets could correct overnight. And what if they did? The rich would be a good bit poorer, and Biden would have achieved some of his social goals. And a stock/bond market crash could provide an excuse for yet another stimulus program. But we doubt that any President wants to preside over such a market debacle. We’ll see.
Sources:
- S&P Global Ratings, “2020 Annual Global Corporate Default And Rating Transition Study” April 7, 2021
Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DGS10, May 19, 2021.
RELATED: PART 4 – COST OF CAPITAL | ARE WE PLAYING MUSICAL CHAIRS?
Want to Discuss This Further?
This post and the accompanying exhibits were produced in-house by members of the Gordian team. Clients, potential clients and members of the media can book a call or meeting to learn more by contacting Leslie Glassman directly.
Commentary by Gordian Group CEO Henry Owsley and Managing Director Liam Ahearn