The Federal Reserve’s (Fed) shift to a tighter monetary policy is resulting in a higher, more normalized level of interest rates. This shift up in rates is creating ripple effects across the capital markets. In short, users of capital now must pay significantly more to borrow money. If you look at new bond issues, particularly in high yield bonds, it is now not uncommon to see coupon rates of 8%, 9%, 10% or even higher. This is expensive and burdensome for many companies. But, interestingly enough, not all companies are suffering.
One way we have avoided much of the damage in the bond markets this year was by focusing on high-quality balance sheets — companies that had more cash than debt and no need to tap the capital markets in the near term. We call these “self-funding” companies, which can maintain their operations and capital needs through cash on the balance sheet and free-cash-flow generation from operations. We consider bonds of these types of companies to be “money good.” Their lower risk profile helps us to sleep better at night, especially when the markets get volatile and unpredictable.
One of the more interesting observations we’ve made this quarter — and a logical, although overlooked outcome of higher rates — is that not all companies with debt are being hurt by 2022’s surge in interest rates. At first, we thought that net debt-free balance sheets made sense just as a way to hide in high-quality/self-funding balance sheets (companies that did not need to access the capital markets to refinance), and avoid the higher interest burden that highly levered companies may face in this environment.
But the additional benefit to cash-rich companies is that their interest income is now also surging. Higher market interest rates are allowing these companies to earn more on their cash balances. And since they have no need to refinance debt today, their interest costs stay the same and are locked in at historically low interest rates. This is creating a situation where some companies — even the high-yield-rated ones — are now generating more in interest income than they are paying out in it. What a unique and enjoyable situation for credit investors!
This should be an area that we continue to try to take advantage of going forward — especially since the market is not pricing these securities any better than other credits that are not experiencing this income benefit.
This Chart of the Week displays Google’s interest income data. Google is an extreme example, as their interest income is now more than $600 million per quarter while their interest expense is only $100 million. So their net interest income (shown in this week’s chart as a dark gray bar) is more than $500 million.
Key Takeaway
Through our bottom-up credit research, we attempt to identify any situation where we can minimize risk and find value. As interest rates increased this year, bond markets felt the pain of this shift back to a normalized hurdle rate, which impacted the prices of all assets. Fortunately, by keeping an eye on the bottom-up, we identified that not all companies are suffering from higher rates — some are actually benefiting.
A focus on great, cash-rich balance sheets is a bias for us to begin with in our Balanced Income strategy. And now, it makes even more sense if we can keep finding individual situations that can profit from this dramatic shift in policy. Even though Fed Chair Jerome Powell’s printer is no longer “brrrr-ing,” we have found various companies that are still printing money.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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