Most economists and market observers expect the Federal Reserve to begin raising interest rates in the next 12 months or so. There is no guarantee that it will happen, but that's the smart money's best guess.
When that happens, the cost of borrowing money will rise not just for car loans, mortgages, and other consumer debt, but also for the nation's largest and most critical businesses and industries. Don't worry, though; those businesses are ready.
Locking in rates and preparing for higher debt service
When looking at the debt of a company, there are two very fundamental considerations: How expensive is the debt, and can the company afford to make the regular payments? It's not dissimilar to evaluating your own mortgage loan -- how much will your bank charge you in terms of interest, and do you have the income to make your monthly payment?
The difference, of course, is that businesses borrow in denominations of millions and billions, while most households only borrower in the tens or hundreds of thousands. However, if not managed properly, the consequence is the same: bankruptcy.
First, let's tackle interest rates. Right now, short-term and long-term interest rates are very low. That's great for borrowers because it means that debt is very, very cheap.
According to a recent report published by Wells Fargo, the average maturity of corporate debt averaged 14.8 years at the end 2014. That's the longest maturity since economists began keeping track of the metric in 1996. That number has ballooned since 2004 when the average maturity was just shy of eight years. Since 2007, the average maturity has ranged between 12 years and 14 years, making the 2014 figure a breakout higher.
This is a significant change, and it speaks to the preparations being made by businesses. By locking in longer maturities, many of these businesses are also locking in lower rates. The theory is exactly the same as that followed by a homeowner who had refinanced a house during the past few years. There's no reason not to lock in today's cheap money for as long as possible. For homeowners and businesses alike, Warren Buffett has called this strategy a "no-brainer."
When rates rise, businesses that have taken advantage of these longer maturities won't feel any pain on the bottom line. Their interest expenses are essentially locked in.
Any cash flow implications?
Longer maturities are obviously related to a company's long-term debt. Most companies also operate with at least some short-term debt to manage cash balances, operating expenses, and working capital needs. Those shorter-term loans are more likely to change in line with the prevailing market interest rates because the loans are reviewed and repriced more frequently.
A rise in rates could potentially put businesses that rely more heavily on short-term debt into a cash squeeze. If payments go up, is there enough cash to pay the higher interest expense?
According to the same report from Wells Fargo, the answer to this question depends on the type of business. For example, the report finds that small manufacturers -- defined as those with less than $25 million in assets -- tend to have a higher ratio of short-term debt, but also a higher interest-coverage ratio. That means that while these businesses are more exposed to an interest-rate hike, they also tend to have a larger cushion in their cash flows. That trend holds true for other industries, from retail to durable goods.
It's also worth noting that many larger and more sophisticated corporations will also utilize financial hedges to protect against interest rate swings -- both short and long term. Those hedges, when properly structured, can simultaneously lock in a low rate and also protect cash flow.
Macro versus micro
For investors, the generalities we've discussed here are only a starting point. Every company makes different decisions as to how it structures its debts, both short term and long term. Some longer maturities could have variable rates, which could negate some of the benefits discussed here.
Likewise, every company's profits and cash flow are different. A 10% increase in expenses could bankrupt one business while hardly affecting another.
The devil is in the specific details of a potential investment. By understanding the macro picture, investors can prepare to review how a specific company has positioned itself, and understand how it compares to the business community at large.