How U.S. Companies are Responding to Higher Interest Rates
Basic economic thinking tells us that when interest rates rise, individuals and corporations will borrow less. Higher rates mean higher interest payments, and they also cut into expected returns from borrowed capital. Given interest rates have been climbing steadily since early 2022, one might reasonably expect that corporations have substantially pared back borrowing (via bond issuance) over the past year or so.
They haven’t.
During the week of September 4 – which is typically a busy week for borrowing as Wall Street returns from summer vacation – investment-grade corporations issued bonds at a record pace. On September 5 alone, 19 companies sold 47 bond tranches in the U.S., the highest number recorded since 2012. Bond sales totaled nearly $38 billion on that day, which was the largest amount of corporate bonds sold since April 2020, when interest rates were effectively 0%.1
High levels of bond sales come at a time when investment-grade corporations are paying an average yield of 5.7%, for companies refinancing is about 2% higher than the bond they’re replacing (on average). As readers can see in the chart below, that’s the steepest yield in over a decade. High quality firms have not paid this much to borrow since the Global Financial Crisis.
Corporate Bond Yields (Moody’s AAA-Rated)
It’s clear from issuance, however, that corporations are still choosing to borrow. There may be a couple of reasons why.
First, some corporations may feel some uncertainty over where interest rates are heading from here. The Federal Reserve continues to express caution about the inflation fight, and the U.S. economy has been delivering better-than-expected growth to date. The idea that interest rates could tick even higher from here – and stay there for a period of time – has some companies betting that now is a better time to borrow than three or six months from now.
But a second, more compelling reason for high levels of borrowing, in my view, is that corporations have optimistic outlooks about both economic and earnings growth – and they want to invest.
On one hand, fiscal incentives to invest are high at the moment. Government programs like the 2022 Inflation Reduction Act, the Infrastructure Investment and Jobs Act, and the 2022 CHIPS Act in total will deliver about $2.4 trillion in new spending, which has already resulted in hundreds of billions of new investments in areas like semiconductor chip factories. A look from the Q2 earnings season found that over 60% of S&P 500 companies increased investment over the past year. As seen in the chart below of private nonresidential fixed investment, year-over-year growth has averaged about 10% – even as interest rates have climbed over the same stretch.
Business Investment (Year-Over-Year % Change)
Corporations are paying more to borrow, but it’s also true that spreads (the difference between yields on investment grade bonds and 10-year U.S. Treasury bonds) have narrowed over the past few months. I think this narrowing spread is largely a result of an improving economic outlook, combined with strong corporate balance sheets.
Bottom Line for Investors
I’m not making the argument that higher interest rates are meaningless to individuals or businesses when making decisions about borrowing and investing. However, the data above suggests that the relationship between interest rates and investment/economic activity is not quite as linear as is often suggested. Sometimes higher rates put a major dent on investment and borrowing, thus hurting economic activity and resulting in recession. But sometimes they don’t. The overall stability of the U.S. housing market, in the face of higher mortgage rates, underscores this point as well.
There are also areas of the market where higher rates do make a big impact, such as with less creditworthy corporate borrowers or those with high debt loads relative to earnings. For these companies, higher rates are much more of a major issue, and default risk is likely to keep going up. From a fixed income investor standpoint, these would be bond issues to avoid.
Disclosure
2 Fred Economic Data. September 5, 2023. https://fred.stlouisfed.org/series/AAA#
3 Fred Economic Data. August 30, 2023. https://fred.stlouisfed.org/series/PNFI
4 Fred Economic Data. September 15, 2023. https://fred.stlouisfed.org/series/AAA10Y#
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