Last week, SocGen’s Albert Edwards marveled at the ostensibly bizarre juxtaposition between falling debt costs and rising rates.
“Something very strange has happened,” Albert said, referencing the decline in corporate interest payments amid the briskest rate-hiking campaign in a generation.
The explanation, of course, is that large-cap US corporates were able to tap the primary market in 2020 and 2021, locking in low rates. Sales and profits subsequently soared, pushing up coverage ratios. In 2022, cash piles were deployed to fund spending, thus shielding firms from the Fed’s hikes, which drove up rates on whatever portion of that cash wasn’t spent.
As Edwards wrote, “Companies have effectively played the yield curve in reverse and become net beneficiaries of higher rates.”
On Monday, his colleague Andrew Lapthorne took a closer look at this dynamic and came to the same general conclusions. “We have long recognized that debt — and therefore rising interest rates — is not directly a problem for large-caps,” he began.
The picture is quite a bit different as you make your way down the ladder, though. Interest cover for US small-caps is 2.5x, Lapthorne observed. It’s 13x for the largest US companies. That disparity is always huge, but it’s a remarkable factoid nevertheless.
The figure above shows how rapidly the effective rate for corporates in the bottom 40% of the S&P 1500 is rising. It’s a right-angle trajectory. By contrast, the effective rate for the largest companies has barely moved.
What accounts for that? Well, simple: It’s the funding mix. Small companies have to rely on revolvers, terms loans and other variable rate financing options, whereas S&P 500 companies just issue bonds.
Just 27% of S&P 500 debt is due over the next two years. That figure for the Russell 2000 is more like 60%.
“Albert’s conclusion is therefore a valid one,” Lapthorne went on. “US large-caps do seem to be benefiting from the negative yield curve.”
But that doesn’t mean a recession isn’t possible. Large companies can shield themselves from higher rates, but they can’t shield everyone else. And “everyone else” is the rest of the economy.
As Lapthorne put it, “interest rate effectiveness has been blunted,” but rising rates still bite eventually via “the impact of tighter financial conditions in the rest of the economy that ends up doing the damage via disappointing demand.”
If you’re wondering how lucrative corporate cash balances are with the funds rate at 5%, Lapthorne had an answer. Assuming all of it earns the funds rate, it went from generating around $5 billion yearly to more than $100 billion. The top 10% of companies by market cap control 70% of those balances.
Related: Explaining The ‘Strangest’ Thing Albert Edwards Has Ever Seen
