Companies Making the Smart Moves for Long Term SuccessThere are two ways to look at interest rates: as an investor and as the company issuing debt. As a consumer, you obviously know that higher rates mean higher expenses. Well, the same goes for businesses; they have to evaluate the expected return when it comes to long-term investing versus the financing cost of the debt.
While interest rates have risen substantially over the past couple months, they’re still at extremely low levels historically. My belief over the past year has been that we are about to embark on a reverse course in interest rates over the next five to 10 years.
Over the past year, many companies have taken on additional debt by issuing bonds to help allocate their long-term investing goals with the current interest rate environment. This is actually a very astute business planning strategy.
While many people who have been looking at long-term investing might view more debt as being bad, they’re really not looking at the big picture. If a business can achieve a rate of return greater than their financing costs, this is a positive for shareholders. However, if the Federal Reserve begins adjusting monetary policy, this will create an upward move in interest rates—a move that I’ve been forecasting for some time.
What does this mean for stocks?
Let’s go back to that initial goal of creating shareholder value.
If you are a business owner with a project that can create an eight-percent return on capital and your interest rates are five percent, that difference is the increase in equity for shareholders (three percent). However, if interest rates rise to eight percent, or close to that level, that positive return has evaporated, and the project no longer makes economic sense.
On the opposite side of the equation are investors. Many large institutions looking at long-term investing need higher yields. While interest rates have risen, they are still extremely low. Corporate debt is an attractive option since many companies have extremely strong balance sheets and can offer additional yield as compared to long-term Treasury interest rates.
This combination is leading to a massive frenzy for corporate debt. The latest example will be a record-setting bond issuance by Verizon Communications Inc. (NYSE/VZ). Verizon will be spending approximately $130 billion to buy the remaining stake of its joint venture with Vodafone Group Public Limited Company (NASDAQ/VOD). To pay for this purchase, Verizon is looking to sell approximately $49.0 billion worth of bonds.
To show the true level of demand for long-term investing in corporate debt, most analysts were expecting Vodafone to initially raise only $20.0 billion. It turns out that Verizon has received in excess of $90.0 billion of orders for the debt.
With interest rates for this bond issuance expected to be 2.25%–2.75% above interest rates for comparable U.S. Treasuries, long-term investing institutions are able to gain additional yield, and the company is able to lock in very long-term debt just prior to what I believe is a multiyear increase in interest rates.
For someone interested in long-term investing, I would look at stocks that have the proper allocation of capital that won’t be negatively impacted by higher interest rates. What this means is that when it comes to long-term investing, you might want to avoid companies that will have debt maturing over the next few years, as they will have to essentially refinance at interest rates that I believe will be significantly higher than the current rates.
This article Companies Making the Smart Moves for Long-Term Success was originally published at Investment Contrarians
More Business articles from Business 2 Community: