Call it the Great Term Out.
After a historic series of interest rate hikes from the Federal Reserve, there’s a big question over just why these higher borrowing costs aren’t having more of an impact on the economy. Sure, there was a small bout of banking drama earlier this year and bankruptcies have ticked up, but overall most companies (and especially the largest ones) appear to be weathering the rate hikes just fine. Businesses are still hiring, consumers are still spending, and the US economy has defied many analysts’ expectations that it would fall into recession this year.
A chart from the latest Bank for International Settlements quarterly review goes someway towards explaining why. As the BIS points out, companies have taken advantage of years of ultra-low interest rates to refinance their debt at ever longer maturities. The trend started after the 2008 financial crisis, but then picked up in the aftermath of the Covid pandemic, when the Fed cut benchmark rates and flooded the system with emergency liquidity.
The chart shows the evolution of the makeup of debt issued by non-financial corporate (NFCs) over more than a decade, with the arrows beginning in 2008 and ending in 2021. As you can see, the majority of companies have spent that time issuing more fixed-rate debt at longer maturities (i.e. the arrows mostly point up and to the right), but one country stands out: the US leads the pack in terms of (ahem) terming out.
Before the great financial crisis, “NFCs’ balance sheets featured mostly debt at short maturities and variable rates. As a result, the policy tightening at that time led to a steady and progressive increase in borrowing costs, which overwhelmed the modest increase in nominal revenues, driving the rise in the debt-to-GDP ratio and the debt service ratio,” write the BIS’s Miguel Ampudia, Egemen Eren and Marco Lombardi. “Before the current tightening, by contrast, NFCs took on more debt at long maturities and at fixed rates, benefiting from low interest rates, generous fiscal support packages and easy credit conditions in the wake of the Covid-19 pandemic.”
It’s a point also picked up Wayne Dahl, managing director and investment risk officer at Oaktree Capital Management, in a recent episode of the Odd Lots podcast. As he points out, not only did companies refinance their debt at lower costs and longer maturities, but they also built up massive cash buffers. Those factors combined to bring down companies’ overall indebtness and insulate them from higher rates — at least for now.
“A lot of corporates built up a lot of cash during the Covid period,” Dahl said. “So much was poured into the economy that yes, they termed out debt. Yes, the rates were lower, but they also built cash and, you know, saw leverage come down.”
The Great Term Out may extend to individuals too. While mortgage rates have surged to more than 7%, so many people refinanced their home loans during the pandemic that the recent surge in borrowing costs just isn’t being felt all that much. Homeowners are choosing to shelter in place from higher rates, and simply opting not to sell or move.
“From an economy perspective, one of the keys to kind of why we haven't felt that interest rate push is in the residential housing market,” Dahl said. “That to me is one of the real keys to why 2023 from a consumer standpoint, from a spending standpoint, from a confidence standpoint, from a growth standpoint, has been a lot more robust than people would've expected,” he said.
Still, analysts at Citigroup Inc. warned earlier this year that some measures of leverage in the corporate bond market have started to creep up, and that companies’ collective financial health could turn quickly if the economy starts to deteriorate and consumers cut back on spending.
“Corporates are currently like big wave surfers perfectly balanced on an 80-foot swell of higher rates, thanks to a board made of cheap financing and resilient consumer behavior,” said Calvin Yeoh, who helps manage the Merlion Fund at Blue Edge Advisors in Singapore. “One wobble in profitability however, threatens that balance and ability to ride this wave to a soft landing. This is the risk to the current makeup of rate insensitivity — it's a question of consumption, not leverage.”
For now though, the US economy shows few signs of a slowdown and looks to still be relatively insulated from higher interest rates. That’s good news for companies and some privileged homeowners, but potentially bad news for a central bank still trying to damp down inflation — or simply understand how rate hikes filter through the wider economy. It’s also one reason why central bankers have been obsessing over the idea that the neutral rate of interest — or the level at which rates are neither loose nor restrictive — might be higher than previously thought.
So the Great Term Out can only last for so long, and eventually US companies will have to issue new and more expensive debt if interest rates stay high. But for now, this particular brand of American exceptionalism means the Fed may have more room to maneuver and raise rates without necessarily putting outsized pressure on the biggest US businesses — at least compared to other countries.
The “Fed can out-hawk other central banks,” quipped Joseph Wang.
Related link:
The Great Rate Reset Hasn’t Happened Yet
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