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News

A Bigger Problem Than Rising Rates

Evan Cooper Oct 21, 2015


Whether or not the Federal Reserve raises interest rates next week when its Open Market Committee meets, there is a widely held belief that interest rates are bound to go up from their current near-zero levels.

Much of what’s driving that view is a kind of reversion-to-the-mean common sense: rates have been so low for so long, they’re just bound to go up. That may or may not happen, and the view of many market observers I respect is that interest rates are likely to stay low for many years, and may even go lower.


Stepping on the Gas


But the problem I’m going to discuss today has less to do with whether rates rise and more to do with the dangers that years of low rates have baked into the economy — and what those dangers mean for dividend investors.

If we look at interest rates since the turn of the century, we see that the Federal funds rate — the rate at which banks borrow from each other to meet the Fed’s reserve requirements — stood at 4.25% at the start of 2001. That rate now stands at 0.25%; a Fed hike would take that rate to a still microscopic 0.5%.

At the start of 2001, the prime rate — what’s paid by the most creditworthy corporate borrowers — stood at 9%. Today that rate is 3.25%.

Since the Fed funds rate is the basis for other rates, we can see the pattern of interest rates in general by looking at what happened to the funds rate since 2001. During that year it steadily fell, ending at 1.75%. Two more cuts in 2002 and 2003 brought the rate to 1%, where it stood until mid-2004.


Down from a Peak


From there, steady hikes brought the rate to 5.25% in September 2007, and steady rate cuts since that date have brought us to where we are now.

At first, the lower rates accomplished what the Fed intended. Corporations were able to borrow at lower and lower rates to repay debt with higher coupons. Lowering interest expenses would theoretically have enabled corporations to invest in plants and equipment — and expand payrolls — to take advantage of business opportunities that lower interest rates made economically feasible.

Instead, many corporations used the low-cost debt to buy back shares, which gives the illusion of greater profitability by increasing earnings per share (which results when the same earnings are divided by fewer shares). That process also tends to drive up share prices, which benefits shareholders, of course, but also swells the compensation of top corporate officers who can financially engineer their take to swell regardless of their company’s underlying health.


Too Much Debt


Today, the balance sheets of corporate America are not all that healthy. On thefiscaltimes.com, Anthony Mirhaydari notes that there has been a rise in credit downgrades and an increase in corporate defaults.

“The ratio of credit downgrades to upgrades has risen to levels not seen since the financial crisis,” he writes. “The problem is that the interest-coverage ratio — or how many times operating earnings can cover a company’s interest expense — for highly rated firms is beginning to fall, down from 11 times to 10.3 times (a level not seen since 2013).”

Equally worrisome is that the ratio of debt to operating earnings among highly rated companies was 2.29 in the second quarter. That’s higher than the 1.91 ratio at the last credit cycle peak in June 2007.


What Investors Must Do


With debt levels high at large companies — the nation’s key dividend payers — dividend investors must stay on alert. As mentioned in yesterday’s column on Treasuries, investors should keep a keen eye on balance sheets and stay away from highly indebted companies. Make sure coverage ratios are low and try to find companies where insiders are not selling. Dividends are great insulators against normal market dips when the companies paying the dividends are in good health. But when that health is in question, not only dividends may be impaired, but the stock price itself is bound to come under pressure.


Image courtesy of sscreations at FreeDigitalPhotos.net

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