This is the title of a brilliant 15-minute video by billionaire investor Carl Ichan. This is a clear discussion of some topics that no one else is talking about with the same level of clarity. Ichan’s common sense approach explains how low interest rates and other factors have created risks for stock and bond investors.
#1- Borrowing rates are at record lows
Interest rates are at near-record lows. One key measure of interest rates is the Fed Funds rate. This is the rate at which banks and credit unions can borrow from the Federal Reserve. As this chart indicates, the rate is at a 50-year low, practically zero.
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The Fed rate is the basis for all other lending rates. The Fed’s Discount rate is currently .75. Banks must have can certain dollar amount of reserves on deposit at the Fed. The Discount rate this is the rate that commercial banks can borrow from the Fed to meet reserve requirements. A bank’s Prime Lending rate is 3.25. Prime is the rate that banks charge their best customers.
#2- Income investors need to earn a rate of return
These low interest rates are kept in place to help the economy recover from a deep recession. Specifically, companies can borrow at much lower rates, which lowers their interest costs. You can borrow money cheaply to raise capital and grow your business.
All good news for a business- but bad news for an income investor.
Investors need income for different reasons. A retiree wants to invest and generate retirement income from interest payments. The pension fund manager needs to earn a return on pension plan assets to fund pension payments (liabilities).
Since companies are borrowing at record low rates, the corporate bonds they issue pay very low interest rates. The trouble is, the retiree and the pension manager still need income- where do they go?
Many are investing in equities.
#3- Do income investors understand the risks of equities?
Ichan’s point is that the income investor may not understand the risks they’re taking with their principal (original investment). If you buy a bond of decent quality and hold it till maturity, there’s a good chance that you will receive the full face amount of the bond on the maturity date. With stocks, your original investment is subject to market risk– the risk that the stock price will decline.
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We currently have a situation in which income investor are bidding up the prices of stocks. These investors are “chasing rates of return” by investing in stocks. More buyers increase stock prices.
#4- Operating earnings matter
A healthy company drives earnings from continuing operations. If you manufacture denim jeans, for example, you should drive your sales and earnings primarily from making and selling denim jeans. Selling a piece of machinery would generate non-operating income.
The problem with non-operating income is that it is not sustainable. There are only so many pieces of equipment you can sell. Your goal should to focus on making and selling denim jeans to drive earnings.
#5- Quality of corporate earnings
Ichan makes the point that merger and acquisition (M & A) transactions are also at an all-time high. Part of the reason is that it’s currently cheap to borrow money. Another reason, however, may be that the CEO is trying to drive earnings by buying a competitor or merger- activities that are not sustainable.
If you merge or acquire another business, there is certainly the opportunity to gain some synergy and take advantage of some economies of scale. If both companies make denim jeans, you can negotiate lower denim prices with vendors, for example.
The concern that Icahn points out is that this type of earnings growth is not sustainable. At the of the day, the denim jean company needs to make and sell denim jeans to earn a profit.
#6- Beware the plastic steering wheel CEO
A friend of mine once described an executive as a plastic steering wheel CEO. Remember when you were a kid and (boys in particular) rode in a car that Mom or Dad pushed? The kid honks the horn and turns the steering wheel- but someone else is really driving (pushing the car).
What my friend meant is that it’s easy to look good when thing are easy. To some extent, record low interest rates make running a company easier. Borrowing costs are cheap- you have some room to recover if your business decisions aren’t the best.
However, management will get more difficult when rates go up- and they will, eventually. Higher rates will increase the cost of raising capital. Poor decisions will be more apparent. It will become tougher to drive earnings.
#7- Junk bonds will be impacted
In an environment of higher interest rates, issuers of junk bonds will be heavily impacted. By “junk”, we mean bonds with the lowest credit ratings. These are companies that run the highest risk of not making principal or interest payments.
Higher interest rates mean that the yield a junk bond issuer must pay will go even higher. If they pay 8% now, what happens when investors demand 10%? Can the firm cash flow the required interest payments?
#8- Chasing yield using junk bonds carries risk
Given all of these factors, the junk bond investor is taking on an increasing level of risk when rates go up. If an income investor is chasing yield buy investing in junk bonds, do they understand the risks?
Keep in mind that all bonds prices will decline as rates increase. Say, for example, that IBM has a 5%, 10-year bond outstanding. Interest rates increase. Investors can now earn 6.5% on a 10-year bond of the same quality. The price of IBM’s 5% bond will decline.
With junk bonds, the price declines are more dramatic.
#9- Stop and think
Icahn’s great video should give us all some food for thought. Consult with your financial advisor about these issues. This is a critical time to stop, consider and think about how your investment portfolio is structured.
Have talked about these issues? I’d love to hear from you.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
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