Since the start of the year, I’ve been writing, on occasion, about a possible rise in interest rates and how it might have adverse impacts for heavily indebted companies and real estate investment trusts (see here, here, and here). A significant amount of the financial commentary I’m seeing speaks of rising interest rates as having a high chance of occuring the moment the US Federal Reserve decides to slowdown (see this for an example), or even remove completely in the future, its programme of large scale financial-asset purchases that’s popularly known as Quantitative Easing (QE). The…
Since the start of the year, I’ve been writing, on occasion, about a possible rise in interest rates and how it might have adverse impacts for heavily indebted companies and real estate investment trusts (see here, here, and here).
A significant amount of the financial commentary I’m seeing speaks of rising interest rates as having a high chance of occuring the moment the US Federal Reserve decides to slowdown (see this for an example), or even remove completely in the future, its programme of large scale financial-asset purchases that’s popularly known as Quantitative Easing (QE).
The simplified idea behind the Fed’s QE program is that it has been pushing interest rates down by buying up massive amounts of Treasury bonds, to the tune of some US$85b a month currently. And to be fair, I was also in that camp, thinking that interest rates will likely rise when QE is eventually phased out as that omnipresent ‘downward pressure’ would no longer be there.
But lately, I’m beginning to have second thoughts about this. That’s because of data I’ve seen recently that’s compiled by my American colleague Morgan Housel in his April 2013 article titled Everything You Know About What the Fed Is Doing May Be Wrong.
In it, Morgan wrote (emphasis his):
“The Fed has played around with quantitative easing for the last four and half years [ending April 2013]. But during that time it’s gone in fits and starts, engaging in QE, then stopping, then starting up again. There have been several periods since 2008 when the Fed has purchased huge amounts of Treasuries and mortgage-backed securities, and several periods when it purchased no bonds at all, leaving the market to itself…
… [But] every time the Fed has begun a new QE program, interest rates have gone up. And every time the program has ended, interest rates have gone down. Every. Single. Time.”
Of course, he has the data to back it up, which he displayed in a chart that I’ve copied here:
Morgan has his own plausible reasons to explain this phenomenon, which he gave in the article I’ve referenced earlier, so I would not be repeating them.
But suffice it to say that, in all likelihood, no one really knows where interest rates should be if the Fed wasn’t involved. And by extension, when the punchbowl’s taken away, interest rates might not even rise like many has predicted – the real world just isn’t so black and white.
So, if there’s even the possibility that interest rates might not increase even with the end of QE, does that mean that investors should still be cavalier with the investments in their portfolio and not be mindful of the risks of high leverage in the companies, REITs or business trusts they are vested in? I’ll argue no.
That’s because, regardless of the interest rate environment we find ourselves in, companies have the potential to run into financial trouble when their balance sheets become bloated with debt. And, there’s no surer way for investors to lose their shirts than with companies that enter bankruptcy.
As the late Walter Schloss, a member of billionaire American investor Warren Buffett’s inner circle and a superb investor himself, is fond of saying (emphasis mine), “I like to look at the balance sheet and I don’t like debt because it can really get a company into trouble.”
It’s true that we can analyse a company’s cash flows and interest coverage ratios and determine if they’ll be able to meet interest-payment obligations and refinance or repay existing debt that’s coming due.
But that doesn’t change the fact that having a large debt load is like standing on a stool while having a noose tied around one’s neck that can be tightened anytime, should the stool stumble.
And like what financial adviser Carl Richards says, “Risk is what’s left over when you think you’ve thought of everything else.” There are just too many ways that risks embedded in a highly-leveraged balance sheet can come back to haunt us.
To be clear, I’m not disparaging debt totally. There are cases of highly intelligent, opportunistic, and astute use of high leverage by chief executives of publicly-listed companies to help fund acquisitions and grow the business for the benefit of shareholders.
John Malone of cable company Tele-Communications Inc. in the USA from the early ‘70s to the late ‘90s was one such example. You can find out more about Malone’s outstanding use of leverage in William Thorndike’s book The Outsiders.
Coming back to leverage and investing, I guess it’s natural to want to know where we stand at the moment in terms of indebtedness in the market. Let’s take our cues from our local stock market bellwether, the Straits Times Index (SGX: ^STI).
Using the latest available data from S&P Capital IQ and FTSE, the STI’s weighted total debt to equity (TDE) ratio for its 30 constituents stands at 78%. On first glance, that’s not too bad, but as it is, there’s always a large dichotomy within Singapore’s blue chips, be it in terms of valuation or leverage.
On one end of the spectrum we have stock exchange operator Singapore Exchange (SGX: S68) and aircraft-engineering services provider SIA Engineering (SGX: S59). Both have a low TDE ratio of effectively zero.
On the other end, we have companies like commodities trader Olam International (SGX: O32) and the supply chain manager of agricultural, industrial, and energy products Noble Group (SGX: N21). Those two sport much higher TDE ratios of 218% and 122% respectively.
Investors should perhaps keep a tighter watch on the ones with higher leverage. If interest rates rise, they might be suffering the most and if interest rates remain stagnant or even fall, these companies still face large financial risks as credit markets (i.e. the accessibility to debt) can freeze in a relatively short span of time as seen during the Great Financial Crisis of 2007-2009.
Foolish Bottom Line
I certainly won’t profess to know for sure where interest rates will go. I’m still inclined to think they will rise in the future, but like I’ve mentioned, some of the data I’ve seen do give me pause.
But more importantly, my thoughts of where interest rates might end up in the future won’t change my proclivity for preferring to invest in companies with low or even no debt. After all, those carry the least financial risks and stand the best chance of protecting my portfolio from whatever extra risks life can throw at me, after I’ve thought of everything else.
Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool's free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what's happening in today's markets, and shows how you can GROW your wealth in the years ahead.
The Motley Fool's purpose is to help the world invest, better. Like us on Facebook to keep up-to-date with our latest news and articles.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.