With the talk of interest rates and recession in the headlines, I figured it was a good time to check-in, and give a little update on interest rates and how lowering them can impact the economy, issuers, and investors.
Why is the FED cutting?
Basically, the FED is cutting to extend the current economic expansion we are in.
The fundamental reason behind that is lower interest rates encourage corporations and consumers to spend more.
For two reasons.
One, they get paid very little, in interest, to put their money in the bank. And two, they are able to borrow money at lower rates.
Current income needs
People who need income, retirees, for example, invest their money in income-producing securities. Often times, those securities are fixed income instruments, like bonds.
Bonds pay interest on a semi-annual basis. The higher the credit quality of the issuer (company or government entity) the lower the payout. The inverse is true for a low credit quality issuer.
It’s the ever-present adage in investing, more risk equals more potential for reward.
When interest rates continue to creep lower, then those people start to make different choices.
What people are doing now
People are getting paid less, in interest, to invest in high-quality debt issuers, so they’re getting riskier. Meaning, they are investing that money with low credit quality companies and/or government entities.
Their risk of not receiving interest payments and getting their principal (the initial investment) back goes up.
The FEDs tool kit
I’ve touched on this point a few times in the past, but I’m going to hammer it home.
The Federal Reserve, essentially, has two tools. Lowering interest rates and buying Treasuries. Lowering interest rates promotes spending and buying Treasuries provides liquidity.
Because they are lowering interest rates during an expansion (whether we are still in one or not is debatable, but let’s say we are for the sake of argument), they are, effectively, removing the number of tools they have available.
When the next recession comes, my fear is they won’t be able to do enough to help us out of it.
Currently, the amount of corporate debt in the market is the largest in history. Additionally, the amount of debt that’s rated BBB is also the highest in history.
BBB is the last rung on the investment-grade scale. Investment grade is anything BBB and above.
That’s a problem for basically one reason. When a BBB rated issuer gets downgraded (to BB) they are classified as junk (high-yield). When that happens, they need to tighten up their debt and improve their balance sheet. This means less borrowing and less spending.
It’s a dynamic that feeds itself. The issuer is downgraded, they spend less, GDP gets weaker, more corporations follow suit, and here comes the recession.
Once the corporate (high-yield) debt pops, issuers of debt will have trouble meeting their obligations. They’ll start to default, and their investors will be left high and dry.
This post is not intended to scare people, it’s to inform.
One last point. Because interest rates have been so low for so long, there are economists/academics that think the lowering of interest rates won’t actually help.
*The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Past performance does not guarantee future results.