Rising interest rates affect many business entities directly by having an impact on their revenue, expenses and balance sheet items and indirectly by the effect on macro-economic variables such as household income, assets and consumer behavior. Whether a business owner or CEO is concerned about cash flow, financing expenses, capital raising, refinancing, operating costs or profitability, it can be very important to consider and mitigate possible negative impacts that rising rates may have on the enterprise.
To illustrate the importance of evaluating the effect of rates climbing, we review the story of the frog that got boiled alive. As the story goes, researchers found that when they put a frog in boiling water, the frog immediately jumps out. On the other hand, when they put a frog in cold water and heat the water slowly over time, the frog stays comfortable, doesn’t jump out and eventually the oblivious animal meets its demise at elevated temperatures. The point being that that when the change in temperature is quite gradual, the frog does not realize it is heading for an untimely end until it’s too late and it has no energy left to escape. What if we substitute interest rates for temperature and a business enterprise for the frog? How can an enterprise cope well in the world of higher priced money?
Removing the Punch Bowl
Given that a low interest rate environment has prevailed in the U.S. for almost a decade, a brief historical perspective can be useful. Lasting from December 2007 to June 2009, the Great Recession propelled the unemployment rate to 9.5 percent and forced a fall in GDP of 4.3 percent, the largest output decline in the U.S. since the Great Depression of the 1930s. In response, the Fed aggressively lowered the federal funds rate to almost zero (a range of 0-0.25 percent) in December 2008. Just a year earlier, the benchmark rate had been 4.50 percent. Now, we are seeing the reversal of the long lived easy money trend, as this key rate has reversed course and climbed to 2.0% amid indications that it will go higher.
Stimulus and Response
The low interest regime was intended to spur business investment by lowering the cost of external financing. And to an extent, it did. But the abnormally low interest rates of most of the least decade lead to a spate of corporate borrowing, which has hit new highs. Some of those borrowed funds have allowed companies to grow faster and invest in the future. Moreover, access to low-cost funding, has allowed companies to reward investors with ‘huge dividends and share buybacks’, according to a CNN Money analysis. This turn of events has resulted in higher corporate leverage ratios. By Q3 2017, corporate debt relative to GDP, at 45 percent, had reached record levels. Such an elevated degree of corporate debt is cause for concern. Earlier this year, in its first 2018 semiannual report to Congress on monetary policy, the Fed warned that ‘leverage in the nonfinancial business sector has remained high, and net issuance of risky debt has climbed in recent months.’
Large debt loads could prove especially burdensome as interest rates rise, particularly if obligations have variable or floating rates that are linked to a benchmark, such as the Prime Rate or LIBOR. They could also be ominous signs of an impending downturn. The prime rate has risen from 3.50% two years ago to 5.00% – an increase of over 40% in borrowing costs, while 3-month LIBOR has doubled in the last year.
The 45 percent ratio of non-financial corporate debt to nominal GDP growth driven by ‘interest rates, which have remained low even as the economy hits what appears to be a cyclical peak.’ is ‘roughly the same level reached before the last two recessions’, says Joseph Lavorgna, chief economist at the investment bank Natixis, in a Fiscal Times feature. If the economy does experience a slump or if rates do rise, as they seem set to do, it will become more difficult to pay down or refinance the $4 trillion of corporate debt that’s coming due by 2022. Higher rates mean, among other things, higher interest expenses for corporations, which reduces earnings and available cash; this coming at a time, when “high-debt companies are also adjusting to significant changes in the corporate tax code”, since “the new law reduces companies’ ability to deduct interest payments from their tax bill.” (CNN Money)
Applying the Brakes
Although it did not raise the federal funds rate from the 1.75-2.00 percent range on August 1, 2018 the Federal Open Market Committee (FOMC), the Fed’s rate-setting body, signaled it would likely do so before the year was out. Fed Chairman, Jerome Powell, advised that “with a strong job market, inflation close to our objective and the risks to the outlook roughly balanced, the FOMC believes that — for now — the best way forward is to keep gradually raising the federal funds rate.” (NYT)
Rising interest rates affect many business entities directly by having an impact on their revenue, expenses and balance sheet items and indirectly by the effect on household income, assets and consumer behavior.
The Macro-Economics of Rising Interest Rates
The indirect or broader economic effect, depends, in the main, on three factors. First, the interest rate determines the tradeoff between consumption and saving, since one is the opportunity cost, or price, of the other. When we spend, we pay a “price” that is equivalent to the amount we may have earned by saving and investing that cash. Conversely, the decision to save involves the cost of forgoing immediate consumption, of enjoying the item or services we might have purchased.
Higher rates discourage consumption, i.e., spending by consumers, because they increase the reward for saving. When rates of return are high, saving becomes an attractive proposition and the pain of postponing consumption can be mitigated by the investment gain of putting one’s cash into a certificate of deposit, say.
Second, higher rates discourage investment, i.e., capital spending by businesses, by raising the cost of borrowing. A higher rate will narrow the margin between returns and cost of borrowing, other things being equal. And will make some previously feasible projects turn unprofitable. Together, the reduction in consumer expenditure and business spending acts to reduce aggregate demand, the total demand for goods and services in the economy. Higher rates also reduce the construction of new housing, considered another form of private investment, because of its long-term nature, for the same reason: mortgage loan costs go up.
Higher rates also reduce the likelihood of inflation, i.e., increases in the price level, by choking off demand.
How Rising Rates Affect Businesses Directly
The direct effect of interest rate changes on businesses can be seen by examining income statements and balance sheets.
For non-financial entities, the P&L item most likely to be affected will be interest expense, more so if the business is using short-term or variable rate debt. A business using short-term debt, will find refinancing or rollovers costlier, if rates are rising. Moreover, payments on variable rate debt, typically tied to a benchmark like LIBOR and the Prime Rate, can rise sharply as noted earlier in this piece. Higher financing expenses will not only reduce income but shrink available cash flow. Operating expenses can climb if suppliers raise prices to offset increases in their cost base from rising rates.
On the income side of the ledger, the primary concern should be the potential for falling demand due to or related to higher rates. This is particularly the case for capital goods which your customer is likely to need to finance, or an interest rate sensitive sector like housing and construction. But adverse impacts are not restricted to purchasers of large ticket items. For example, a company that provides marketing or advertising services may face a decline in demand from customers who choose to reduce or forego such discretionary activities to offset rising payments to lenders.
As for balance sheets, we pointed out earlier in this note that debt-to–GDP is at peak levels, so the key issue here is how leveraged is the balance sheet of the business and whether it can withstand the impact of rising rates without triggering debt defaults, covenant breaches and the like. The enterprise needs to ask: Are there options available to reduce leverage? Can the business find creative ways to reduce financing costs or improve debt coverage? Are asset values likely to be lowered by rising rates? For example, will customers pay more slowly in response to higher rates, reducing receivables turnover, or are there likely to be higher charge offs for uncollectable receivables? Generally, the higher level of leverage or gearing due to a fall in the value of assets may make an enterprise riskier to providers of capital, while the reduction in income and cash flow may lower valuations.
Conclusion
Because the impact that rising rates may have on your business depends on many factors it is important not to be lulled into a false sense of complacency by gradual changes in the rate environment and continue with “business as usual”. We recommend reviewing the impact of rising rates on the business at a strategic level at the earliest. Helica can partner with you to help you accomplish this quickly, given the breadth of our experience and familiarity with rate and economic cycles. Contact us today.
