Management Teams Have Less Discretionary Capital as The Cost of Debt Rises
As the cost of debt rises, management teams have less discretionary capital to allocate toward growth initiatives and various sources of competitive differentiation (Product Development for example). Belt tightening will be required as corporate America braces for the new normal of higher input costs and less accommodative monetary policy.
Share Buybacks: Given that the cost of debt has risen dramatically, we would expect to see share buybacks taper off for many companies. The game of issuing cheap debt and using the proceeds to boost the value of company shares and options packages via share repurchases got substantially more expensive to play over the past few months.
Variable Rate Corporate Debt and Loans:
- Corporate loans: Corporate loans have grown dramatically over the past decade from approximately $2.1 trillion in Q1 2012 to approximately $4.7 trillion as of Q1 2022. Most of this debt is variable rate (we don’t have the exact allocation between fixed and variable rate, but believe the mix is similar to 2017 when the Federal Reserve did a study on non-financial corporate loans when the mix was 84% variable rate, 16% fixed).
- If we were to assume that 80% of the $4.7 trillion outstanding in corporate loans is variable rate, that means that approximately $3.8 trillion of corporate loans have growing interest expense.
- In addition, those companies that carry fixed rate corporate loans (or fixed rate non-loan debt for that matter), will experience higher interest expense when fixed rate loans and debt securities issued in previous years are rolled over at higher rates.
- Corporate debt: Corporate debt securities outstanding are approximately $7.5 trillion.
The Fed To The Rescue: We believe the probability of a credit crunch similar to the financial crisis is low given that the Fed is at the ready to run the printing press. I don’t believe that Fed Chair Powell will allow the credit market to break. I hope I am wrong. The market is contaminated with moral hazard as a result of the 2008-2009 bailouts as well as the bailouts of 2020 and 2021. The U.S. Treasury along with the Federal Reserve – beginning with the easy monetary policy of 2008 – have effectively nationalized the capital markets which, pre-2008, were actually primarily private markets. Back then, players such as Goldman Sachs, Citi, J.P. Morgan, Fidelity, Vanguard, Allianz, Citadel and others lorded over the capital markets. Those players remain influential, yet it is the U.S. Treasury and Federal Reserve that are the primary market movers today. No one else comes close.