Many of America’s most preeminent firms have taken advantage of the prolonged low interest rate environment to borrow prodigiously. Some have used this cash wisely by investing in their business (or purchasing other businesses at reasonable prices) in order to help generate future growth. Some have used the debt proceeds to buy back their shares at attractive prices. Others have used them for less profitable pursuits such as ill‐advised acquisitions or buying back their shares at undesirable prices. Prior to their debt binges, many of these organizations had highly rated corporate debt but have since been downgraded to BBB. Outstanding U.S. debt, rated BBB, currently amounts to $2.2 trillion according to Morgan Stanley (up from $686 billion only a decade ago). BBB‐rated bonds now account for 50 percent of the investment‐grade corporate debt market.
This is disconcerting for many equity investors. As we enter a period of rising interest rates, the amount of maturing investment‐grade bonds is set to double in the next two to three years (including investment grade bonds other than BBB). If the economic backdrop becomes unfavorable, these firms could be downgraded into high yield status. When this occurs, companies could have trouble refinancing their debt or, at a minimum, have to pay significantly more in interest expenses. Paying more in interest expenses systematically reduces the net income in a firm’s bottom line. Either scenario would have a negative impact on the common shares of these businesses. We will monitor such developments as the Federal Reserve continues their rate increases for the foreseeable future.
Turning to the Federal Reserve, several weeks ago it announced another 25‐basis point interest rate increase. The Federal Open Market Committee (FOMC) has also prescribed for two more rate increases (a total of four for this calendar year). The ECB (European Central Bank) is also set to conclude their bond buying program at the end of the year. As the world’s second most important lending region, the ECB’s action will likely drive additional upward interest rate pressure. As we have observed previously, interest rates are like gravity, the higher interest rate/gravitational force, the harder it is for asset prices to elevate.
As always, please feel free to reach out to us with any questions that you may have. We are grateful for the trust that you place in us.