Back to the Future: What financial engineering moves will companies make as rates rise?

As we try to make sense of the markets and their movements, trying to look back for a parallel in history is useful.

You can have real market growth, or you can have financial engineering growth. The latter is a bit of smoke and mirrors.

You’ll recall that when the Federal Reserve did drive interest rates practically down to zero, at least at the short end of the curve, that the long end diligently followed. There was a tremendous incentive for companies, specifically large corporations, to issue debt.

Why?

Because there was a tremendous hunger for yield. Secondly, they were pretty good credits and so everyone was willing to lend money to them.

And what did these issuers do with all the cash? They did what anyone would do who’s got “cheap money.”

  • They bought back their stock, in droves, because by reducing the share float you are essentially increasing your share price.

  • They paid themselves a nice rich dividend.

The overall effect was that companies reengineered their balance sheets. They took on more debt and took equity off the balance sheet. That’s great for your balance sheet, because interest on debt is tax deductible. So you’re getting a double benefit.

That’s a great strategy when rates are low or moving lower.

But when the engine goes into reverse, things don’t work as well. As rates have risen, a few interesting things have happened.

Who bought all this debt?

The banks, insurance companies, and pension funds did. And they’re sitting now with some amount of mark to market losses on their books, which they may or may not realize. They may say that since they are holding these credits to maturity, they’ll get it back and so it’s not a real loss to them. But theoretically there is an economic loss that is being sustained by these bondholders and that is going to come through the system at some time.

The other thing is the sheer magnitude of issuance of debt is going to become lower. It’s already done so. That means the level of buybacks may decrease as there is less money available to carry them out.

These loans will need to be refinanced, or they’ll mature or become extended. Companies who went over their heads in leverage may find it harder to go out and refinance the debt. But yet they’ve got these high interest rate payments. This starts crimping profits and this of course hits the equity markets.

Greg Silberman, CIO, gsilberman@acgwealth.com

David Crook, Global Economist, dcrook@acgwealth.com

This material is provided for informational purposes only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The views and strategies described may not be suitable for all investors. They also do not include all fees or expenses that may be incurred by investing in specific products. Past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. You cannot invest directly in an index. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. The opinions expressed are subject to change as subsequent conditions vary. Advisory services offered through ACG Wealth Inc.