The conventional wisdom is that Macy's (M 0.06%) has too much debt and could suffer if interest rates continue rising, as they have throughout 2018.
That might have been true a couple of years ago. However, this conventional wisdom is wrong today. In fact, now that Macy's is using its prodigious free cash flow to steadily reduce its debt load, the company could actually benefit from further interest rate increases -- as long as they don't spiral out of control.
Macy's debt isn't what it used to be
As recently as late 2016, Macy's had $7.5 billion of debt. Even after deducting its cash, net debt stood at more than $7 billion. But since the beginning of 2017, debt reduction has been one of management's key capital allocation priorities, along with investments in the business and dividend payments.
Macy's has had plenty of capital to allocate, due to a combination of strong free cash flow and asset sales. As a result, by the end of last quarter, the company was down to $5.5 billion of debt -- and only $4.5 billion net of cash on hand.
This put Macy's well within its stated long-term target leverage range. Nevertheless, the retailer has indicated that it plans to continue using its excess cash to pay down debt through the end of fiscal 2018 (if not longer).
Macy's plans to continue reducing its debt this year. Image source: Macy's.
Why rising rates help
If Macy's were actively borrowing money, rising interest rates would be a problem, because they would drive up its interest expense. But since the company is instead repaying debt ahead of schedule, higher interest rates are a good thing. Bondholders can get higher returns from reinvesting their capital than was possible a year or two ago, so Macy's will be able to repurchase its debt at lower premiums or even at a discount to face value.
The interest rate on 10-year government bonds has surged to nearly 3.2% from 2.4% at the end of 2017, including a jump of about 0.3 percentage points just since late August. This has driven the price of Macy's bonds down. For example, its 7% bonds due in 2028 traded for as much as $111 per $100 of principal in late August but now fetch just $107 (and as little as $105 last week).
Macy's typically generates more than 100% of its annual free cash flow in the fourth quarter. It also expects to receive the vast majority of its $340 million to $370 million in asset sale proceeds for the year during Q4. Thus, the company is likely to repurchase a substantial amount of debt over the next few months.
Last December, Macy's completed a tender offer for $400 million of its outstanding debt. Macy's is entering the 2018 holiday season with a significantly larger cash cushion, so it could potentially afford to spend an even larger sum on retiring debt while it is advantageous to do so due to recent interest rate increases.
Modest rate increases could help in other ways
Higher interest rates could have other benefits for Macy's. The company's pension plan was already overfunded at the end of fiscal 2017, but higher interest rates will boost its funding ratio even further by allowing the pension fund to earn a higher return on its investments.
While Macy's isn't allowed to withdraw cash from the pension fund, this overfunding reduces the risk that the company will have to make future contributions. It could also enable the pension plan to adopt a more conservative investment policy going forward, protecting it from a potential stock market downturn.
At some point, rising interest rates could cause trouble for Macy's, but not because of its balance sheet. The more likely risk related to high interest rates is that consumers would pull back on spending if credit becomes significantly more expensive.
Fortunately, the risk of runaway interest rate increases that would severely damage the economy seems contained for now. As a result, Macy's shareholders are set to benefit as rising rates cut the cost of Macy's debt reduction efforts and add to its pension surplus.
