Corporations Are on A Borrowing Binge, Should You Do the Same?
Interest rates are widely misunderstood. In their purest form, we feel the best description would be “the rate of interest is the price of money.” But that’s something of a head scratcher because we really don’t “buy” money, we either have it or we borrow it.
A better analogy would be to think about interest rates similar to the cost of leasing a piece of equipment—interest rates are the price paid to lease (borrow) someone else’s money.
Left unadulterated by outside interference, the interest rate charged would be largely determined by the lenders assessment of the probability the money will be repaid. Obviously, there is more to it than that, but it’s not hard to understand that the less secure the borrower or the collateral, the higher the interest rate charged.
Pretty simple and seemingly reasonable, but we don’t live in a world where the “price of money” is left untouched by outside forces.
The Federal Government manipulates the price of money in a host of otherwise private transactions, and that intervention comes in many different forms.
When Congress intervenes, their approach commonly puts the Federal Government at risk for defaults, allowing lenders to be more comfortable lending to less credit worthy borrowers. Government backing lowers the interest rate charged.
This is done to encourage economic activity in areas Congress deems deserving.
The Federal Reserve Bank (the Fed) also intervenes in the price of money. One policy tool they use is the interest rate they charge banks (large banks borrow from the Fed as one source of money used to make loans).
If the Fed want to encourage lending, they lower the cost of money they charge banks. Banks then have cheaper money with which they can lend to the public, encouraging lending activity and economic activity along with it.
When the Fed lowers rates, it flows through the economy as lower interest rates across the board; they are lowering the price of money.
For people with savings, they earn less on their money. This is intended. The Fed hopes to drive savers out of safer interest paying deposits and loans, into riskier investments.
We see this happening when individual investors scoff at the low rates on bank savings or fixed income investments; they start favoring alternatives such as higher yield stocks or pass-through limited partnerships like real estate investment trust (REITs). They look for anything with a (often described) “decent” yield.
They expect to earn more on their money and are apparently willing to assume the added risk by moving to completely different types of investments. That’s a topic for another time.
But that’s the whole point of lowering interest rates when economic conditions are faltering: the Fed wants to both encourage lending and bolster the value of riskier investments.
In March of this year, when markets were collapsing and businesses were shutting down, the Fed pushed their borrowing rate to near 0%. They were doing what they could to support the economy.
Companies, facing an uncertain future, took advantage of the cheap money to shore up their balance sheets. They sought to raise cash to help weather the crisis.
Between late March and May, investment grade companies issued nearly a trillion dollars of debt according to Bloomberg. Included in that amount was Walt Disney selling $11 billion in bonds in the middle of May, according to Yahoo.
This borrowing was deemed necessary by corporations to ensure they had cash available as sales were collapsing.
But what about consumers? Should consumers respond to low cost money by increasing their borrowing?
Amongst those who are fiscally conservative, the mere suggestion is heresy. During a time of economic uncertainty, where job loss risks are higher, increasing one’s debt seems mildly insane.
Many financial advisors (Nicollet included) tend to construct financial plans with a goal of being debt free. We do not believe current low interest rates changes that goal for individuals. However…
Current low interest rates present opportunities that each of us has to assess in light of our own situation. The most prevalent opportunity is refinancing your home mortgage. Everyone should be looking at refinancing their mortgage and, for many people, refinancing makes sense.
Be careful, however. The cost of refinancing is not insignificant, and if you don’t plan to stay in your home for several years, the cost may be greater than the savings.
The next thing to look at is higher cost debt like credit cards and student loans. If you have higher cost debt, you should consider rolling that debt into a mortgage refinance. I say “consider” as whether it makes sense to do this or not, is a question very specific to your circumstances.
Then there are very unique circumstances that need to be carefully analyzed. Let’s say you have a large expense upcoming and expected to bridge the cost with a withdrawal from your investments. Very low interest rates may now make shorter term loans a more attractive alternative to selling in your portfolio to raise the funds. It just depends on the specifics of the planned transaction.
In our work for clients, we carefully evaluate larger planned expenditures and try to find the best source of funding. For people with investment portfolios, there are a few reasonable options to consider.
So, go and check on refinancing your mortgage, see how much you can lower your payments. If there is more to consider, it’s wise to consult with your advisor. We would be more than happy to look over your options and give you our advice. At Nicollet Investment Management, we help our clients with these decisions all the time.
Give me a call and I’d be happy to share more while answering any questions you may have about this strategy.