The Daily Interview: What the Fed Rate Cuts Mean for Corporations
With the
Federal Reserve
having cut short-term rates by 2.5% so far this year, most media attention has been placed on the effects the cuts will have on consumer spending.
John Lonski |
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But these rate cuts can also affect corporate spending by lowering short-term borrowing costs and improving companies' cash flows. The Daily Interview turned to John Lonski, chief economist of debt-rating agency
Moody's
, to assess what these declining rates mean for corporations.
Lonski says that cash flows have improved for companies as a result of rate cuts, but that they aren't using the money on capital expenditures. Instead, they're refinancing their debt. This reduces financial risk and should eventually help the bottom line, says Lonski, but these positives right now are overshadowed by declining corporate earnings.
TSC: How much of a boost has the decline in rates had on the corporate bond market? Has there been an infusion of capital going to corporations?
Lonski:
The three-month
LIBOR
London Interbank Offered Rate, used as a benchmark for certain types of debt has dropped sharply to 3.88% from a high of 6.8% in October. This has significantly pared the variable rate of U.S. corporations and provided companies with some additional cash flow. The LIBOR has not been this low since the beginning of 1994.
In the first quarter of 2001, we had net interest expense decline from the previous quarter, and we have not seen that since the final quarter of 1998.
Anything that reduces interest costs of corporate America is very much a step in the right direction. But because profitability is in its deepest year-over-year decline in more than 10 years, that tells me that Fed rate cuts are not going to do much to stimulate capital spending.
We think their biggest immediate benefit will be to lower corporate interest expense, which again boosts cash flow for corporate America exactly at a time when such relief is badly needed.
TSC: So, what are bond issuers using the capital for?
Lonski:
Refinancing. For the most part, companies are offering new bonds or fixed-rate debt to retire outstanding variable rate debt that could take the form of commercial paper for investment-grade companies, or bank loans for high-yield companies. The decline in variable rate debt via commercial paper has been astounding. Outstanding U.S. commercial paper, excluding asset-backed commercial paper, was $845 billion at the end of May, down from its November 2000 peak of $985 billion. That's a drop of $141 billion over the span of six months.
This reduced refinancing and interest-rate risk. Companies know what this money is going to cost them over the next five, 10 or 30 years, and they don't have to worry every seven days or every month if they are going to be able to roll over maturing short-term variable-rate debt at attractive terms.
TSC: So is most of the corporate bond issuance right now for refinancing?
Lonski:
Yes. Even commercial paper ratings have been downgraded from P1 to P2
P1 is the highest rating for short-term debt with less than a one year duration, P2 the next highest and because most money market mutual funds are prohibited from holding more than 5% of their assets in commercial paper rated less than P1, these companies are all but compelled to refinance this paper into fixed-rate bonds.
Also, companies that are concerned or worried about the possibility of incurring a commercial paper downgrade are refinancing those financings as fixed-rate bonds.
TSC: Are some of these downgrades healthy, in a sense, because they are pushing companies to refinance in fixed instruments?
Lonski:
I wouldn't necessarily say that downgrades are healthy, but I would say that the movement out of variable-rate into long-term debt reduces financial risk for the U.S. economy.
TSC: How effective should all of this refinancing be in helping companies' bottom lines?
Lonski:
The equity market should approve of these refinancings, and over time, they should improve companies' bottom lines.
But the most important impact would be that the refinancing of short-term variable-rate debt as fixed-rate long-term bonds reduces refinancing risk. That is the most important aspect, and that is difficult to quantify. But it should help companies' financial performance over time. Fixed-rate bonds tend to insulate interest expense from changes in creditworthiness.
TSC: Are there particular industries that have been very active in the corporate bond market?
Lonski:
It's been across the board. High-yield telecommunications have been absent, but in general corporate bond issuance has not been dominated by any one industry.
TSC: Why haven't high-yield telecom companies been active in the bond market?
Lonski:
Their troubling outlook for creditworthiness. These have been a large number of downgrades in that industry, and it's been going through a lot of turmoil. They've lost so much in terms of debt protection as of late. Their earnings performance has been well under expectations.
TSC: Moody's has downgraded a record 32 investment-grade companies to speculative grade so far this year, whereas you made only 16 such downgrades in the first half of last year. Does this indicate a serious decline in fundamentals and a poor outlook for the U.S. economy?
Lonski:
In some cases, they were special-event downgrades brought on by mergers and acquisitions. But there was the fallen-angel downgrade of
UAL
(UAL) - Get Report
that was attributed to the possible acquisition of
US Airways
(U) - Get Report
.
In some cases it's the general deterioration of business conditions.
Navistar
(NAV) - Get Report
comes to mind.
Case Corporation
,
Dillard's
(DDS) - Get Report
. Dillard's fallen-angel downgrade was triggered by problems from an earlier debt-financed acquisition.
We're also having a lot of problems in manufacturing because of slower domestic spending and excess capacity globally as well as an overvalued dollar exchange rate. And a large number of the first quarter's fallen-angel downgrades were attributed to California's energy crisis.
TSC: What about the fact that junk bond defaults hit a record $50 billion over the past 12 months ended May 31?
Lonski:
The default rate was pretty well anticipated. It's not a good sign, and it is very much in line with the deterioration in creditworthiness that has resulted from the worst earnings in more than 10 years. As long as we suffer from a shrinkage of profitability, creditworthiness will continue to be affected. There will be far more downgrades than upgrades, and with that a high rate of defaults in the junk bonds.
TSC: So, in sum, what does the bond market tell you about your outlook for the economy?
Lonski:
The corporate bond market is offering good returns. Year-to-date, we have a total return of 6.8% for investment-grade corporates. That's much better than the 0.6% return from Treasury bonds and the 3.8% return from high-yield bonds. Compare that to the 5.5% year-to-date return of U.S. equities.
As far as high yield is concerned, it is premature to declare a bottom for the downgrade-to-upgrade ratio. That means, it is too early to state with confidence that the corporate credit cycle has bottomed, in part because of the weakness of the equity market, which puts pressure on the assets that would be used as collateral for debt.
In terms of the economy, we are going to have a weak second quarter. It will barely grow from the first quarter. Third-quarter growth will probably grow to 2.5% annualized from the second quarter. And the surprise might be the final quarter of this year when the U.S. economy perhaps grows from 3.5% annualized from the third.
The U.S. economy will gradually regain momentum, thanks to the Federal Reserve rate cuts and tax cuts and rebates.