Cost of Capital. The Past, Present and Future? | Part 4

Time to Pay the Piper? A Look at the Prospective Cost of Capital

In the first three 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. In this fourth installment, we take a closer look at the dichotomy between inflation and interest rates and that impact on asset prices.

Are We Playing Musical Chairs?

Inflation is in the wind and in the news.  You cannot ignore its potential for havoc.  Global tensions are, if anything, rising.  Domestic tensions have not been this concerning since at least the 1960s.  Some pundits are comparing our current situation to the lead-ups to the Civil War and to World War I.

Yet cost of capital indicators remain in a state of torpor.  Even with the recent Fed announcement about potential interest rate hikes in 2023, the 10-year Treasury yield remains around 1.5%.  The BB spread over Treasuries is 2.3%, implying an all-in yield for “good junk” of less than 4%.  The CCC spread is 6%, lower than it has been since immediately prior to the 2008 meltdown.  According to Aswath Damodaran (a financial guru at NYU), Equity Risk Premiums have plunged to levels below 4% – a level that, while not unheard of, is certainly well below average.

RELATED: PART 1 – COST OF CAPITAL | PAST, PRESENT AND FUTURE?

What gives?  There are at least two parts to the answer.

Part One – The Treasury Rate

First, the Treasury rate has been manipulated by the Fed in an environment where the world is awash in money.  Cash is trash.  So, investors have been settling for 150 basis points (for a 10-year T Bond), compared with virtually zero for short-term instruments.

In our view, this may be a very risky game of musical chairs.  Assume inflation concerns do become baked into security prices overnight, causing 10-year Treasuries to yield 2.5% (a 100 basis point increase, but a fraction of the 9-plus percent Treasury rate witnessed during the Carter Administration).  Were the rate to “only” increase to 2.5%, the bond price would drop from par to 91.

To us, that is not merely a questionable bet.  It also represents a real risk if inflation-juiced rate increases cause snowballing selling and a rush to the exits.  In short, we would not count on 1.5% to be the prevailing Treasury rate for all that much longer.

Part Two – “Cash is Trash”

Second, the “cash is trash” view of many investors also enters into the determination of risk spreads.  And this dynamic is reinforced by the unprecedented economic stimulus packages that are being developed.  It is also reinforced by an investor belief that financial assets (such as equity and junk bonds) will produce a better real return (i.e., after inflation) than cash.

But what happens if the risk spreads increase?  Events relating to China, cyberterrorism, domestic unrest, and a myriad of other issues could cause this.  Clearly, the eventual tapering of economic stimulus programs will increase company-level risk, particularly at the lower end of the credit spectrum.  Material increases in the risk spreads will drive security prices down a lot.

Again, we question the risks and rewards to investors of holding securities with razor-thin risk premiums.

RELATED: PART 2 – COST OF CAPITAL | IMPLICATIONS FOR THE FUTURE

Having said all that, there is no question that markets conditions can continue in irrational territory for extended periods of time.  Until there is some precipitating event that starts a rush for the exits, or a massive rotation into value plays and other securities that benefit from inflation.

RELATED: PART 3 – COST OF CAPITAL | INTEREST RATE DILEMMA

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.