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Credit Vista: The Silver Lining of Rising Rates

Tim Lee, Senior Credit Research Advisor

With the Fed set to begin normalizing monetary policy, corporate America appears well positioned to handle a higher interest rate environment. For many companies, preparations for rising rates began soon after the Fed lowered its benchmark overnight rate to near zero and initiated a large bond buying program in response to the COVID-19 crisis back in March 2020.

Even as rates on short-term corporate borrowing slid to historic lows due to the Fed’s actions, companies decreased commercial paper usage over the past 18 months, which in turn will reduce their exposure to rising interest expenses whenever the Fed inevitably lifts the overnight rate. After all, we can’t have zero interest rates forever, can we?

Chart 3: Commercial Paper Outstanding Nonfinancial, Not Seasonally Adjusted



It wasn’t just short-term debt that companies reduced. Most recent quarterly data shows that aggregate net debt among nonfinancial companies in the S&P 500 is now below pre-pandemic levels.

Chart 4: Aggregate Net Debt Excluding Operating Leases, S&P 500 Nonfinancial Constituents as of 10/29/2021



Net debt has fallen in part due to an abundance of cash being held by companies. While elevated liquidity will likely moderate over the next year, current high levels of cash will allow companies to forgo some of the short-term funding that they might typically require, thus avoiding some exposure to higher interest expense when the Fed raises its benchmark rate. For example, companies could use their cash hoard rather than borrowing for capital expenditures, to conduct M&A or even to repurchase shares. And while liquidity is waiting to be deployed, corporate cash would benefit from rising short-term interest rates by earning a higher return. Oddly enough, some companies might benefit from a small bump in the fed funds rate.

Chart 5: Aggregate Cash and Marketable Securities, S&P 500 Nonfinancial Constituents as of 10/29/2021



While liquidity increased during the pandemic, in part from long-term borrowing to lock in lower interest rates, cash has also been amassed organically through free cash flow generation. This, too, illustrates just how well positioned companies may be for the rising rate cycle ahead as continued free cash flow generation will reduce the demand for future borrowing at higher interest rates.

Chart 6: Aggregate Free Cash Flow (Cash from Operations Minus Capital Expenditures), S&P 500 Nonfinancial Constituents as of 10/29/2021



We should also acknowledge that low interest rates and quantitative easing programs provided by the Fed and other central banks during the pandemic also helped improve the credit profiles of corporations with pension liabilities. While lower interest rates would normally increase the pension liabilities and decrease pension funding ratios, the jump in asset prices and investment returns experienced during the pandemic helped move the average funding ratio to 94% from a pre-pandemic level of 86%. With interest rates set to rise, corporate balance sheets will benefit again as actuarial pension liabilities decrease with rising rates. In addition, higher rates could provide corporations a chance to lock in their funded status and immunize their pension liabilities at a lower cost.

Chart 7: Average Pension Funding Ratio, S&P 500 Nonfinancial Constituents as of 10/29/2021



With the removal of pandemic-related restrictions accelerating in the US and around the world, premonitions of a protracted credit degradation from COVID-19 have faded fast. Instead, corporate America utilized the pandemic to reduce reliance on rate-sensitive short-term funding, lower net debt and increase liquidity. As a result, many companies have emerged with solid cash flow prospects and shored-up balance sheets. Rising rates are typically not thought of as a positive, but fiscal prudence and planning shows there may be a silver lining to the slightly higher rates anticipated with the coming “more normal” monetary policy.

Trading Vista: Great (But Changing) Expectations

Jason Graveley, Fixed Income Trading

The old Wall Street aphorism, “a rising tide lifts all boats,” might be the simplest and best way to explain the run up in rates across security types. With benchmarks surging, portfolios have been able to take advantage of a higher floor in yields across the curve. A steepening in the front end of the curve has also highlighted a delineation across the maturity spectrum. Consider that the spread between 1-year and 2-year Treasury maturities is currently 38 bps, which is 10 bps wider than the average spread over the past five years. The spread between the 2-year and 3-year Treasury note is currently 28 bps, compared to an average of 9 bps over the past five years.

In short, the pace of increasing yields has accelerated over the last month, but the moves have been concentrated outside of the 1-year threshold. Any move in Treasuries with shorter maturities will likely be blunted by dormant money market cash, which is estimated to exceed a whopping $4.5 trillion in global balances. Coupled with the balances currently invested in the Fed’s reverse repo facility, which stand at approximately $1.4 trillion, and which earn a paltry 5 bps return, there is ample cash available to mitigate any sharp rise higher in T-bill yields. As a result, our focus remains on prudently managing duration as rate volatility increases in the 2-year to 5-year segment of the curve. And as markets continue to parse Fed speaker comments, forward rate projections should only clarify further. We’ll be watching and deciphering.