Roshan Padamadan is an instructor at European Investing Summit 2016.
For debt issuers, or borrowers, a lot of what they pay is the credit risk premium, not the cost of money per se. This is why it is pointless to link corporate propensity to borrow to an endless discussion of the timing and level of interest rates. The market sets the credit risk premium.
A company’s relative strength can come from a lower credit risk premium compared to its competitors. All else being equal, it could use this to devastating effect, passing on lower capital costs in lower product costs, or pricing to parity, and using lower capital costs to earn supernormal profits. (Berkshire Hathaway, as a reinsurer, is a good example). Being a good, sustainable business has its own feedback loop, in the form of a lower credit risk premium, allowing cheaper funding, and capital is a key input for most industries.
On a level on par with Tulipmania (how future generations might struggle to understand this ever happened), we now see people willing to surely lose money. We saw the world’s first negative yield corporate bonds this week in September 2016, for a non-government backed entity. Even in this, there is a credit risk premium. The German bunds trade at a larger negative yield than the small negative yield of the issuers ¬– Henkel, Sanofi issued short-term bonds at -0.05% vs. Germany’s current 2-year bund yields at -0.65%. People are willing to lose more if the issuer is safer, around 50bps in this case. If you think you are unaffected, look at who buys such stuff? They are the people who insure your life, and invest your pensions.
Do you think you will ever get capital at negative yields? (Borrow from family?)
The lending institutions or investors always add a risk premium to adjust for the perceived riskiness of all entities over and above a chosen fundament. The global benchmark is the US government bond yield. In various other currencies, the local government bond is chosen as the safest in that particular country. For assessing the riskiness of said country, one compares the yield of that country’s USD sovereign bonds with that of the US. The riskiness of a particular corporate is compared to the sovereign bond of that country (in same currency and same tenor) to get the specific risk premium.
To analyze the role of credit risk premium’s role more easily, let us look at the other extreme: An individual with no collateral, and a low-paying job. (If you lend to anyone with no collateral and no income, it is charity, hopefulness or foolishness). Credit card loans are priced at ~40%, while the lending institution might be paying close to zero on retail deposits (at present, in most developed nations). If a bank buys 10-year government bonds at 1.6% yield, and lends (invests) to credit card customers at 40%, the credit risk premium is over 38%, or over 95% of the cost of credit. A 10 bps or 25 bps change in the rate of interest if not going to change the propensity of borrowing for this borrower. The riskier you are, the less the cost of money matters, most of what you are paying is for your own riskiness. (In one way, it is the cost of not being able to have your own police, ability to make new taxes, etc. Never call a Government toothless).
The credit risk premia is not pure profit. It is the topline for the bank in terms of credit risk: you subtract the expected losses (true cost of credit), operational costs, and funding costs (not always zero. As a separate entity, when a credit issuer borrows money, it pays much more than zero, reflecting the economics of unsecured lending). The true cost of credit is never known for sure in advance, but it is estimated. Provisions are used to reserve and account for this cost, but cyclicality in expectations means that provisions in the good times are often proven inadequate, and write-downs in bad times are often proven excessive, in hindsight.
Money, in the lending market, still behaves as a normal good, and it is priced with the oldest pricing principle – “what the market can bear”.
For those who like puzzles, one could study Denmark, and its success in working with negative rates. Some lucky customers get paid for their home loans.
The Central Bank rate for deposits is as high (or low) as -0.65% for deposits. Even in Denmark, retail deposits are at 0% – no bank in the world will dare impose negative interest rates on retail deposits, as it the same as inviting a bank run, and an imminent bank collapse. No bank has enough funds: by design they are levered 6-10x and they do not have the money. Hence the negative interest rate impact is solely on corporates, both in and out of Denmark. Home prices in Denmark have risen more than 40% between 2010 and 2015, in a search for yield. Denmark might not help us solve the issue, but reminds us that the lower bound for retail deposits is zero.
People invest in themselves to get education and experience. For a banker, that by itself does not add value, or lower the credit risk premium. So, if you walk into any bank in the world, and show them your CV, your CFA credentials, etc., and ask for money, you will in fact get nothing. Yes, nothing. Your CV has no value, without a job. Yes, there was once a time, I got an education loan for business school, but my dad and uncle had to hand over collateral to get the loan sanctioned. My credit was enhanced with collateral.
Both an unemployed undergraduate and an unemployed graduate would not qualify for a housing loan (let’s forget the subprime mania period, where banks allowed loans with no documents, because they were going to flip it anyway. I am not able to decide who was more out of their mind: the bankers or the investors). The only thing the banker cares about is your disposable cash flow, after taking care of fixed expenses such as rent, other loans, etc.
A thumb rule evolves from a study of the maximum credit given to a person. Usually 5 years gross income is a metric for allowed total debt exposure for individuals. Try asking your bankers for a loan bigger than that, and they will start asking for more collateral such as your (personal) investment portfolio, guarantees from others, etc.
For companies, investors get jittery when loans cross key thresholds, such as 3.5x Net debt to EBITDA or 5x Net Debt to EBITDA. Bondholders usually ask for 3.5x, banks usually accept 5x. Who is more conservative? Why the different ratios? Banks believe they have more control, and usually take more senior position to bondholders, and are closer to the cash: working capital, salaries, factoring receipts, etc. may sit with the main bank. You will see a very different risk appetite from a bank that is not the primary bank of the company. The bondholders demand a tighter ratio since they are further away from the cash.
Using credit risk premium to understand a company is a good way to look at equities too. Equity is just one more step removed from the cash, and thus weaker than the bondholders, who stand behind the bank. So should you not accept a tighter leverage ratio, and also demand a higher earnings yield?
The S&P 500 is at ~25 P/E (12-months trailing, beginning of September 2016), or an earnings yield of 4%. In terms of equity risk premium, that is only 2.4% over the US 10-year government yield. Dimson et al(1) found that historical equity risk premium was about 5-6%, in their seminal study of 17 countries over 100 years. Are you sure you want to accept such a low risk premium? Are you enhancing your equity investments’ credit with adequate collateral or other enhancements, if you are invested in global equities right now? Pick your spot carefully in the corporate structure, and see if it is fair compensation. How can you enhance your protection, can you be a friendly activist, or a partner, if possible? Engagement might serve as its own form of risk mitigation and collateral enhancement by improving business prospects, and reducing risk of a surprise.
(1) Triumph of the Optimists: 101 Years of Global Investment Returns, by Elroy Dimson, Paul Marsh, & Mike Staunton (ISBN: 9780691091945. First published 2002).