-- Corporate debt interest rate will rise across longer maturities by an aggregated increase of 55 bps as corresponding treasuries’ real yields reverse back toward zero
-- The debt costs of corporate will thus go up by as much as 25%
-- The increased costs can be completely offset by improving corporate profits
-- Tapering’s hesitation is more related to other things than corporate profit and job market
The Fed’s $80B monthly purchase of treasuries with different maturities has played an exclusive role in artificially distorting the required return of risk-free asset investment and, by the smooth transfer of alternative investment costs in the debt market, thus dragging down the cost of corporate debt.
If the Fed stops purchasing treasuries the distortion in the open market of debt will be fixed immediately. Some reasonable and accessible measures useful in estimating the correction in treasuries yields include the extent to which the corresponding TIPS yields of 3 years or longer maturities bounce back and the interactive influence that Fed fund rate and treasuries’ buying put on 2 years or shorter treasuries.
Our model indicates that the aggregated increase in financing costs of corporate as measured by increase in interest rate of corporate debt due in one year after the Fed’s stopping purchasing is about 55 bps (assuming 1. Corporate debts are distributed as the following: 25% of debts maturing in less than two year, 50% in 3-10 years, and 25% in more than 10 years; 2. in order for long maturity treasuries’ real yields to reverse back toward zero, their nominal yields go up as the following: 90 bps for 3-10 years treasuries, and 30 bps for more than 10 years; 3. Change in FFR in 2 years is insignificant. 4. capitals transfer smoothly from risk-free investments to risky ones).
The current 55 bps interest rate cut in corporate debt, simply as a result of Fed’s heavy purchase of treasuries, used to weigh significantly above FFR cut for companies to fight pandemics. However, its contribution to lowering corporate costs is being diluted as corporate profits rise largely under the current inflated economic situation.
Our equation indicates that, caused by a 55 bps increase in corporate interest rate as a result of a complete tapering, corporate interest payment will increase by 25%. However, 100% of the increase can be offset by the increase in corporate profit attributable to sales price hike ( assuming an aggregated interest rate of corporate debt of 1.8%, an average interest coverage ratio of 3, and an inflation of 4%).
In addition, if we assume a 7% GDP growth, which may mean about 3% increase in sales volume beyond a 4% sales price hike, all added interest costs mentioned above will be completely ignored by employers when considering new hiring.
