It's A Low, Low, Low, Low-Rate World
COVER STORY PODCAST
Wait a minute—weren't long-term interest rates supposed to be a lot higher by now?
When the rate on the 10-year Treasury bond plunged from 6.5% in early 2000 to an average of 4% or so in 2003, the explanations were easy: tech bust, recession, weak capital spending, low inflation, steep rate cuts by central banks around the world. The low rates seemed perfectly normal—and sure to reverse on a dime when conditions changed.
Since then, plenty has changed. The Fed has hiked short-term rates by more than four percentage points. The global economy grew by 5.1% in 2006, the second-strongest performance in 25 years. Europe and Japan have recovered. Even tech spending seems to be on the rise, judging from Cisco Systems Inc.'s (CSCO ) strong earnings report on Feb. 6. And yetand yet!—10-year Treasury rates have risen only three-quarters of a percentage point. Real rates, which adjust for inflation, have barely budged.
It isn't only a U.S. phenomenon. Ten-year euro bonds are yielding around 4% today, no higher than in 2003, despite much faster growth in the region. Real rates in the euro zone are up only a bit.
Borrowers, of course, are deliriously happy. Even the shakiest companies are seeing their debt costs plunge. The spreads on triple-C rated bonds and lower—the junkiest of junk—are at a record low 4.7 percentage points over ultrasafe Treasuries, compared with the previous record of 5.2 percentage points in 1997, according to Merrill Lynch & Co. (MER )
Most remarkably, the craziness isn't likely to stop anytime soon. The low cost of capital is probably going to last "five to seven years," says Samuel Zell, who as chairman of real estate firm Equity Office Properties Trust (EOP ) watched bidders wield cheap debt in a fight over his company. (Blackstone Group, with a $39 billion bid, won out on Feb. 7.) James W. Paulsen, chief investment strategist at Wells Capital Management (WFC ), sees an even longer horizon: "This could be a prolonged cycle where the cost of capital is low [for] 10 or 20 years."
It is, indeed, a low, low, low-rate world.
Easy money is creating all sorts of economic benefits. Corporations are making capital investments again—and with their borrowing costs so low, profits are still zooming. Private equity firms are using loads of cheap debt to buy companies at jaw-dropping prices. Even the housing market, which boomed for five years on cheap money, hasn't fallen apart. It's gliding to a soft landing rather than a hard crash, allowing consumers to keep spending. "We are in this era where financial innovation and product structuring, particularly in the debt markets, has been very stimulative," says Henry H. McVey, chief U.S. investment strategist at Morgan Stanley (MS ). Zell puts the state of rates in similar terms: "I think that's going to be a growth accelerant around the world."
But the easy money also brings a slew of unexpected problems. Historically, risky borrowers have had to pay much higher interest rates on their debt. Now there's little penalty—and that means there's less incentive for companies to stay fiscally sound. Low rates aside, other borrowing terms are getting easier, too. Many debt deals being made today have fewer protections for investors in case companies can't pay. "I've never seen issuers have this much power," says Raymond G. Kennedy, a bond fund manager at PIMCO with 26 years' experience under his belt. Kingman D. Penniman, founder of KDP Investment Advisors Inc., a bond research firm, sees a dark side to this: "You're laying the groundwork for future turbulence."
The shift to a low-rate world doesn't mean lower volatility. In fact, excesses, crack-ups, and bad investments are not only possible but guaranteed. "Over the next several years there's likely to be some event that will widen out the spreads," says Zane Brown, director of fixed income at mutual fund manager Lord, Abbett & Co. But when the dust has cleared, he says, the world economy will likely be left with a lower cost of capital than the average over the past 5 to 10 years.
In some ways, it's the 1990s all over again. Back then, the info-tech boom created an unexpected boost in productivity that persists today. Now it looks like something analogous has hit the global financial markets. A combination of globalization, innovation, and good old-fashioned competition among markets has made it easier and cheaper to raise and deploy money. Borrowers now can draw funds from around the globe. And derivatives let financial institutions and traders manage their risks with mind-blowing precision. With Chicago, London, New York, and Frankfurt all jostling to be the world market leader, exchanges and financial institutions have an incentive to be cheaper, faster, more innovative.
At the same time, the low rates reflect major imbalances in the global financial system. The developed countries, led by the U.S., have systems that are good both at raising money and allocating it. Emerging markets such as China have only half of that equation: They can collect the money, but they don't have the financial institutions that can put it to the best use. According to a November, 2006, survey of executives by McKinsey & Co., only 40% of respondents in China and Latin America said their company's access to external funding is good or very good.
Eventually the financial systems in China and India will improve, and a lot more of their capital will be used at home. That won't happen anytime soon, though. In a new book, The Next Great Globalization, Federal Reserve Governor Frederic S. Mishkin writes: "It takes a long time for any nation to achieve strong property rights and an effective financial system."
For now, China and the other emerging markets are serving as key suppliers of capital in increasingly connected markets. "People are more willing to throw their money across borders and across currencies to get the highest yields," says David A. Wyss, chief economist at Standard & Poor's (MHP ). Indeed, in just the past year, the value of outstanding international debt securities—debt raised in foreign countries or foreign currencies—has risen by 20%.
It's a continuation of a long-running trend. Since 1990, cross-border capital flows have been rising at a 10.7% annual rate, adjusted for inflation and exchange rate fluctuations, says a January, 2007, report from the McKinsey Global Institute. That's up from just 4.3% from 1980 to 1990.
An essential part of the globalization story is the adoption of the euro in 1999, which created a huge pool of highly mobile capital from lots of smaller pools. "The euro markets are today much bigger than what they would be if we had not had the euro," says Jerry del Missier, co-president of London-headquartered investment bank Barclays Capital (BCS ).
The second key factor is the development of new trading instruments. Financial innovation isn't new, of course. Mortgage-backed securities date to the 1970s, and junk bonds came to life in the '80s. But innovation seems to have reached a fever pitch with the recent advances in collateralized debt obligations (CDOs), which keep borrowing costs low by dividing risks into big buckets and then reallocating them among hundreds of investors. With nearly half a trillion dollars' worth issued in 2006 alone, and with the risks widely dispersed, investors are willing to put more skin in the game. "Financial innovation in the form of CDOs has changed the risk premium associated with the bond market," says McVey.
Put the two together—bigger markets and innovation—and you have the makings of a global financial revolution. Adding more fuel, exchanges are becoming more entrepreneurial—which, as always, brings down costs. There's bustling competition from online exchanges as well. "When oil prices were very high and airlines needed to hedge the prices of jet fuel with options, they had no idea if investment banks were ripping them off, because there was no transparency in the price," says David Gershon, CEO of SuperDerivatives Inc., an online derivatives and options exchange. Gershon's outfit is among a handful of startups that allow investors to trade sophisticated instruments online. He argues that exchanges like his make markets more transparent and create more liquidity.
These changes have helped reduce the real cost of capital, best measured by the interest rate on low-risk Treasury bonds. Economists don't expect much of a change over the medium term. The Congressional Budget Office projects 10-year rates will average just 5.0% over the next three years, compared with 4.8% today.
Even more important is the decrease in the risk premium on corporate borrowing. Investment-grade bonds, issued by the healthiest companies, might enjoy a quarter-point decline in their spread over the low-risk Treasury rate long term. For junk bonds, says Wyss, "we could get a bigger permanent impact on keeping those spreads lower, maybe 100 basis points"—one full percentage point.
The increased efficiency has been beneficial so far. Companies gain from a lower cost of capital in the form of lower interest payments and higher profits. If rates had not stayed so low, corporate earnings would be about 10% lower than they are today.
Naturally, lower capital costs have made it easier to borrow. Duke Energy Corp. (DUK ), a $16.3 billion electric and gas utility based in Charlotte, N.C., plans to boost capital spending by $1 billion a year over the next three years to build new power plants to keep up with the growing demand. Duke may borrow the money instead of drawing down its cash, says David L. Hauser, chief financial officer, since "interest rates have remained surprisingly low." Robert M. La Forgia, chief financial officer of Hilton Hotels Corp. (HLT ), says low rates were critical to his company's ability to purchase its international hotel operations last February, uniting Hilton brands that had been apart for over 40 years. The company put together a $5.5 billion bank line at just 1.5 percentage points above the rate London bankers charge one another. "It's part of what made this deal possible," he says.
But the downside of the long-term trend is short-term financial market excess. It's here, and it's real. "The economy is robust, [but] we've entered into this new phase where the markets are financing riskier transactions," says Mariarosa Verde, head of the Credit Market Research team at Fitch Ratings Inc. Excess is especially evident in the corporate credit markets, where covenants, which protect investors by requiring companies to maintain healthy financial ratios, are becoming less restrictive. Some companies are jamming investors in other ways. When Pittsburg (Tex.)-based Pilgrim's Pride Corp. raised money to buy another poultry processor in January, it issued bonds that allow it to use projections rather than actual results to meet certain financial tests for borrowing more money. Pilgrim CFO Richard A. Codgill notes that the projections have to be "reasonable." Hospital chain HCA Ltd.'s latest bonds include some with provisions that let the company use debt instead of cash to make interest payments to bondholders. It works essentially like an IOU that increases HCA's debt down the road. Says Kennedy of PIMCO: "The bottom line is that when there's too much money in the market, [investors] lower [their] standards." What's more, many are depending on instruments that are highly leveraged, numbingly complex, and untested by a market downturn.
Then again, derivatives might cushion the blow when the reckoning comes. When hedge fund Amaranth Advisors went under, says Brown of Lord Abbett, part of its losses were covered in the derivatives markets. "It barely caused a ripple." Adds del Missier: "We haven't done away with dislocations in markets, but markets are much more able to deal with dislocations, and their impact will be less."
Over the long term, the big issue is the development of better financial systems in China, India, and other emerging markets. Right now money is pouring into real estate rather than infrastructure, education, and other essential investments. As financial systems improve in these countries, they will likely make better use of their own money. When that happens, the cost of capital around the world will go up.
But that's a long way off. In the meantime, rates are likely to remain low. "Whatever shocks are ahead," says del Missier, "the markets are better positioned to deal with them than they've ever been."
By Michael Mandel and David Henry, with Mara Der Hovanesian in New York, Christopher Palmeri in Los Angeles, and Stanley Reed in London