Zeros or Zeroes?

Central banks across the world, collectively and extraordinarily have engaged in loose monetary policies for the better part of the last decade. Globally, there's anywhere between $12-$15 trillion of negative-yielding debt and the US is hurtling toward's this point of no return.

Low Rates

The zeitgeist has everyone falsely convinced that growth can be fueled ad infinitum by keeping interest rates low. It has fueled jaw-dropping stock rallies and enormous asset bubbles.

It is clear though, that these loose policies are not going to work in the longer run.

First, the credit market, which has always been a leader in predicting the direction of the market, has been flashing red for a while. The 10-year yield, which has been falling hard, is a critical indicator since it influences a whole range of loans, including home mortgages. It is signaling an impending lending crisis and implying is that there is nothing in it for debt investors. Why would they pay the borrower to take their money? It's ludicrous.

And here's the complete absurdity of it all. The numbers below are not meant to be an exercise in corporate finance, but examples to elucidate the crisis that lies ahead. A corporation can issue negative-yielding debt, yes, get paid a coupon to issue this debt and instead of investing this money as capital expenditures, buy back any and every instrument on their balance sheet that is more junior to the newly issued tranche e.g. retire either their high-yield debt or even their equity.

It's Absurd

Consider this: a $3bn principal -3% yielding debt buys back or retires a $1bn principal 8% paper; your average interest is now 5% on the $1bn paper and you, the issuer (what?) are getting paid a 3% coupon on the $2bn principal delta. This is not only an immediate reduction in your interest expense payment but also an increase in your debt to capital ratio. When interest rates rise, your coupon payments (or receipts in this case) don't change, but your principal now trades at a deep discount to par. This discount to par rises exponentially as interest rates rise depending on the convexity of the instrument. This is where the negotiation between borrowers and lenders falls apart and we have a credit crisis on our hands.

In theory, when you have negative cost of debt, your discount rate is purely your cost of equity less the tax-adjusted negative cost of debt! So you have a discount rate that is much lower than what it would have been if the cost of debt was positive. As a corporation, this implies that you have received startup-like equity financing, but without any dilution. In fact, this is tantamount to free money and a massive reduction in the corporation's cost of capital, which by definition does not capture business risks.

Valuation Impacts

When the discount rate or weighted-average cost of capital ("WACC") is artificially lower than it's intrinsic value, companies tend to exhibit higher Price-to-Earnings ("P/E") ratios, as the market capitalization goes up in order to give the company that "currency" value to invest in projects or engage in M&A or asset deals. We should think of P/E ratios as the inverse of cost of equity which in the above case is the discount rate or WACC.

In such situations, financings happen in a fast and loose manner. When interest rates rise, and they will, refinancings for corporations with negative-yielding debt is going to be a debacle. Liquidity will fall and the asset bubble will correct, or perhaps even collapse. Levered companies with declining asset bases are going to go bankrupt. As a case in point, some energy companies are zeros.

Last Word

In conclusion, zero interest rates will cause zero weighted average cost of capital for corporations which in turn may cause a liquidity crisis and thus result in zero valuations for some once rates rise.