If a little debt can be a good thing, what then are the best practices? We know from the 2008 Great Depression that excessive borrowing (aka leverage) was a major problem. The collateral upon which leverage applied was questionable, and the number of turns of leverage (the number of times you can multiply the equity to determine the size of the loan) was too high. For example, as a rule of thumb, the IRS allows 9x leverage when making intra-family loans. In other words, $1million of collateral can be used as equity for a $9million loan. This is a valuable and time-tested way to allow family members to borrow from one another, and when properly applied can be a good wealth transfer technique.
The mark of a company’s ability to pay the interest on its loans is known as its interest coverage, which is determined by dividing the interest costs into the free cash flow of the company. The free cash flow is the net income less any deferred payments it owes, plus any non-cash charges that go into the calculation of the net income. If the free cash flow covers both the interest costs and the dividends the company pays, it is considered stable and high quality.
Likewise, for individuals, income from all sources, less taxes, interest, gifts paid and all expenses, plus tax refunds and gifts received should be a positive number. Many individuals have ample assets and cash flow, and thus can afford to borrow if the returns they can achieve through their investments are greater than the interest costs. For the past six years, the Federal Reserve has targeted short-term interest rates between zero and 0.25%. Banks’ costs of capital are a spread above Fed Funds, and the rate at which companies can borrow from a bank with their cash flows as collateral is a number of percentage points higher than that. The more creditworthy the borrower, the lower the rate at which they borrow from banks. Individuals can usually borrow against their own securities more cheaply than corporate bank loans, as their liquid portfolios are the collateral.
Corporations, governments and municipalities also borrow long-term in the public debt markets, issuing bonds that pay a stated interest, normally every 6 months. These usually have a fixed maturity, but the issuers may be able to refinance the bonds during the term if interest rates are lower than when they went to market.
Since we live in a “Credit Cards Accepted” world in which borrowers and lenders meet in the capital markets, we must appreciate the unique times in which we live now. Without the ability to expand their balance sheet (borrow) and use the money to buy securities to keep prices high (and thus interest rates low) governments would not have the ability to step in during times of economic crisis and prevent catastrophic losses.
Bond yields tend to rise and fall with future expectations for inflation, or the change in prices of goods and services. Here is a rudimentary example to begin the explanation: Say the price of Royal Gala apples is $2.00 per pound today, and we expect the price to be $2.20 next year. Then there would be 10% inflation in Royal Gala apples. Well, every month there is a report of prices for raw materials for the makers of stuff (the Producer Price Index or “PPI”) and the prices of a basket of goods and services for the users of stuff (the Consumer Price Index or “CPI”). The higher the inflation expectations, the more a borrower will have to pay a lender to lock up money at a fixed rate, since the lender will need more money for groceries next year and will need the interest on the bonds to help pay the tab. The lower the inflation expectations, the higher the demand for fixed income and the lower the yields.
In the US, inflation is tame but positive. Today’s CPI reading in the US showed a 1.9% year-over-year change for the “core” index—which strips out more volatile food and energy price moves—but the index showed no increase over last month’s. In some European countries, prices are actually falling, which means there is less demand for stuff than supply, thus eroding business and consumer confidence and business activity.
Deflation usually creates the domino effect of lower interest rates, thus individuals make less income from savings (the flip side to lower borrowing rates) lower consumer and business confidence, resulting in a recession in which companies reduce wages and/or employees. Thus, the European Central Bank recently set its borrowing policy at a negative rate, which ultimately means individuals will pay banks and banks will pay the Central Bank to deposit their money. This creates a disincentive to save, and an incentive to lend and invest.
So, like a bicycle pump getting the tire pressure right, the government, through its monetary policy tools, plays a key role in deflating and reflating the economy.
Another sign of this topsy-turvy time is that today many companies pay more in stock dividends than in bond interest. There is more demand for (and less perceived risk in) some companies’ fixed rate bonds than their higher-yielding common stocks. So these companies tap the bond markets at the lowest interest rates in a generation to buy back their shares, pay higher dividends or acquire other businesses. On this latter point, it should be noted that merger activity is at an all-time high. This reduced the number of shares outstanding in the market (the supply), at a time when demand for growth assets is high (because retirees are living longer) and essentially signals that common stocks are undervalued today.
Papa Paul, who lived to age 92, was a pretty straightforward guy. In fact, whatever he was eating would fly straight forward onto his tie (and yours) every night. However, I doubt he had thought through micro- and macroeconomics before crystallizing his thinking around the merits of debt. He just told you it was bad. My late grandmother, Molly, who lived to the ripe age of 100 said, “Everything in moderation.” So, which sage was right?
The way I figure, if governments and corporations are using debt in a sensible, flexible and proactive way, then individuals could and should be doing the same, and perhaps live a fullness of days.