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Among the beneficiaries of higher interest rates will be companies with little or no long-term debt. During the financial crisis of 2008, the problem for debt financing was the lack of available funds, i.e. the credit crunch.
The next year the bond market roared back to life with a boost from the Federal Reserve, which allowed firms marred by bad capital structures to refinance billions in debt maturing by 2014 that was otherwise facing restructuring. Now the price of the Fed's intrusion into the capital markets is coming due in the form of higher inflation and higher interest rates.
With these expectations, high-grade corporate bond yields have been inching up all through the Fed's QE2. The idea of a blue chip firm issuing at 1 percent, as IBM did for its three-year notes last summer, is now obsolete when inflation over the last three months exceeds 5 percent on an annualized basis. As the market value of corporate bonds sinks, we can expect debt-heavy firms to be punished through declining share prices.
If the vista for corporate debt going from bright to bleak in that time frame is surprising, consider what Michael Milken wrote about capital structure in the Wall Street Journal in April 2009: "The optimal capital structure evolves constantly, and successful corporate leaders must consider six factors "“ the company and its management, industry, dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies."
Going back to the early 1970s, Milken charted a trend of firms misplaying capital structure decisions "“ failing to have enough cash on hand to survive credit crunches and overleveraging during good times to buy back stock. His argument was that Merton Miller's Nobel -winning theorem about the irrelevance of capital structure was wrong, and a firm's mix of debt and equity affects its value. But after forty years, why haven't they gotten any better at it? The one factor inside Milken's rubric that has evolved most constantly is the price of debt "“ interest rates.
Interest rate fluctuation has worked to make money artificially cheap in certain periods since the Fed inherited total control of monetary policy in 1971 after the dollar was delinked from gold. Kansas City Fed president Thomas Hoenig estimated in a recent interview that the real fed funds rate was negative 40 percent of the time during the 1970s and the 2000s, the two debt supercycles Milken referred to. When interest rates are so low that firms borrow to acquire targets, wear down working capital, and behave like finance companies when they aren't, these are signals of excessive credit rather than self-imposed financing problems, which is how Milken described the ill-fated leveraged stock buybacks before the financial crisis.
For years firms were told they generally didn't have enough debt and were missing out on leverage opportunities and tax savings from interest expensing. Now companies that finance themselves through equity and retained earnings, including giants like Apple and Google, will have the edge as interest rates rise. Even if demand for corporate debt stays strong, investors will need to be compensated for higher inflation. Debt-free companies will be insulated from this effect. This is one reason why closely-held tech valuations have been soaring.
Merton Miller and his colleague Franco Modigliani posited their capital structure irrelevance theorem in the late 1950s, when the dollar was as good as gold at least for foreign creditors. Debt supercycles and blowouts manufactured by the Federal Reserve were not factors in capital structure consideration or economic life at all. Financial innovation "“ including Milken's high-yield bonds "“ has not been able to keep companies safe from these trends. Right now, a dollar of debt may really not be worth it.
's Categories: 1220, Fact & Comment, Law, Op/Ed, Policy, Regulation, byline=Rich Danker
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Project Director for Economics at American Principles Project, a Washington political organization
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