Higher Interest Rates Would Change Everything

Among my investment notes, I keep a copy of a printout from the 1990 edition of the Moody’s Investment Manual that described the prevailing interest rates at the time. In March 19990, the Treasury bond rate was 9%.

The interest rate on debt was further broken down based on the following rates: AAA bonds paid 9.30% interest on its debt, AA 9.7%, A+ 10%, A 10.25%, A- 10.5%, BBB 11%, BB 11.5%, B+ 12%, B 13%, B- 14%, CCC 15%, CC 16.50%, C 18%, D 21%. We have all gotten so used to low borrowing costs that it requires historical reminders of what the world can look like in the event that credit is not cheap.

If you like at real estate investment trusts, telecom companies, oil drillers, and even some food companies, there are huge debt burdens that have not been fully felt because the borrowing rate has been 4% instead of 9%. In the case of these companies specifically, much of the debt is due for refinancing within five years so a higher interest rate environment would alter the profitability and intrinsic value of the firm.

This is not a theoretical concern to me. I own shares in Anheuser-Busch Inbev, which carries $109 billion in debt. If it had to pay 7% in borrowing costs, it would have to pay $7.6 billion in annual interest. Right now, it is paying $4.0 billion in interest. It makes $9 billion in annual profits. In a sustained higher interest rate environment, suddenly those $9 billion profits would be at risk towards shifting to $5.4 billion. The current $90 per share price of the stock is 20x earnings now, but it would represent 28x earnings at a higher interest rate.

My solution was to insist in a higher discount rate when buying the stock (I paid in the upper $60s and low $80s when I bought it), and also, to make those types of debt-heavy investments the exception rather than the norm. Also, only $29 billion of Anheuser-Busch’s debt is due prior to 2024, so it would have approximately 25 years to adjust to a higher interest rate environment so the sequence of when the payments are due and owing gave me an additional margin of safety.

On the other hand, you have a business like Berkshire Hathaway that is sitting on over $110 billion in cash. All that money sits in treasuries that only generate $2-3 billion in additional funds for Berkshire. If March 1990 bond prices were available, and Berkshire could earn 9% on its money, it would earn over $9 billion per year on its cash hoard. Nowadays, Berkshire would have to make an $80 billion acquisition to add the kind of annual income to its balance sheet that could also be accomplished by returning to March 1990 bond pricing. That is yet another reason to gravitate towards the host of fully valued megacap firms that are sitting on $100+ billion cash hoards.

And then there is the side issue that higher interest rates result in lower P/E ratios for stocks because investors typically demand 6% returns in excess of the ten-year bond benchmark for risking their funds in business.

For high-debt companies, there would be a double whammy striking at once. First, P/E ratios would compress because the risk-free alternatives would be more compelling, and second, profits would suffer to the extent that money would need to be originally borrowed or refinanced at a higher interest rate.

In my own life, I tend to focus on cash-rich companies that would benefit from higher interest rates. I only own two stocks that would be classified as high debt (Anheuser-Busch being one of them), and it is mitigated because the profit sources of the firm are unusually consistent and most of the debt is due more than five years from now so the company could allocate its unrestricted funds towards paying down the debt if the circumstances demanded it. Otherwise, the best practice is to follow Rose Blumkin’s wisdom when she said: “Cash is king and stay away from debt.”

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