Thursday, October 26, 2017

Upside-down CAPM, Part 1: Why interest rates are a poor indicator of monetary policy

I have previously written about an Upside-down CAPM, meaning real total returns on corporate assets are generally quite stable (with some noise) at around 7%.  Those returns are divided between equity and debt owners.  Total real returns of the total stock market can be considered the sum of the long term real risk free rate (estimated by long term TIPS bonds) and the equity risk premium (ERP).  Total real returns of an individual firm are shared between its equity holders (with expected returns equal to some multiple of ERP, depending on the firm's "Beta", or sensitivity to market volatility) and its creditors (with yields equal to risk-free returns plus a credit spread).

Thinking about market returns in this way helps to see how thinking about monetary policy in terms of interest rate targets is not helpful.  Thinking about monetary policy through interest rates seems to lead to the idea that low rates induce leveraged investing, and that this is how monetary policy affects spending and economic growth.  But, interest rates don't systematically affect corporate leverage, at least in terms of inducing speculative cyclical investments.
Here, the red lines are the Fed Funds rate and the 10 year treasury yield.  Generally, when the Fed Funds rate is well below the 10 year yield, this is when monetary policy is generally viewed as being loose or accommodative.  The dark blue line is nonfinancial corporate leverage as a proportion of enterprise value (debt + equity), based on historic cost.  The light blue line is leverage based on the market value of equity, instead of historic cost.

We can see that most of the cyclical shift in leverage is based on collapsing equity values during a contraction, which then recover.  Based on book value, there is usually little cyclical shift.  And, leverage has been declining as interest rates have fallen, both in real and nominal terms, for several decades.  And, when the Fed Funds Rate is low relative to the 10 year yield, there is no noticeable shift in leverage.

The Modigliani-Miller thesis says that debt financing is advantageous for firms because profits are taxed at the firm level, but interest expense is not.  I don't see any reason to doubt that this is true, to an extent.  The counterintuitive result of this is that higher interest rates provide a tax advantage, so that higher rates actually could lead to higher leverage.  In fact, if the total required returns on equities are stable (which I assert that they are), which means that a 1% increase in the risk free long term interest rate will generally be matched by a 1% decrease in ERP, then declining interest rates should lead to declining leverage and declining firm share value!

Note, the Modigliani-Miller effect is nominal, not real, so that it would be related to high leverage in the 1970s and 1980s because of the high inflation rate.  Mostly, this seems to flow through lower equity values, because high inflation increases the de facto tax rate on firm profits.

Interest rate induced cyclical corporate leverage simply isn't a thing.  For as much bandwidth gets used up talking about it, you'd think there would be something there.  There isn't.

This makes sense, if we view markets through the upside-down CAPM model.  First, firms don't borrow based on the overnight rate.  In fact, the iShares Core U.S. Aggregate Bond ETF (AGG) currently has an average effective maturity of nearly 8 years.  This is a mixture of various forms of debt, but the point is that long term yields really are a more important factor in aggregate borrowing costs than short term yields.  And, certainly, a firm will try to match the duration of its borrowing with the duration of its investments, to a certain extent.

Total operating profits to firms don't change because of changing interest rates.  Changing interest rates change how operating profits are shared between equity holders and creditors.  Real interest rates mostly reflect a discount taken by creditors compared to the return claimed by equity holders, because creditors avoid cash flow and market price volatility.

The idea that interest rates would effect corporate leverage is especially suspect when we think about the standard way in which any CFO would manage a firm's balance sheet.  Firms don't leverage up specifically based on each individual project.  They don't say, "Oh, we can now borrow at 3% and here is a project that has come across my desk that returns 5%, so let's borrow cash to make this project happen."  Firms generally use the weighted average cost of capital ("WACC") and they compare the full range of projects to that WACC.  The leverage that the firm targets will be based on a number of preliminary factors of risk and its effect on credit spreads.  In most cases, WACC is largely a product of the returns to equity.  If a firm with any substantial amount of risk was leveraged enough for the cost of debt to be dominant, they would have a high credit spread, which would overwhelm any effects of lower risk free interest rates.

The riskiest firms and the firms with the most pro-cyclical risk tend to be the firms with the highest credit spreads.  They tend to be more equity financed, so that in those cases WACC will especially be immune to changing short term interest rates.  It will mostly be a function of the cost of issuing equity.  In that case, the cost of capital will be related to short term interest rates, but contrary to how people seem to normally think about it.  Let's say you have a highly cyclically risky firm, with a Beta of 2 - twice as volatile as an average firm.  Then, if investors are feeling safe, ERP might be 3% while real long term rates are 4%.  So, the risky firm has a real cost of equity that is 10% (4% + 3% x 2).  But, if investors are risk averse or afraid of cyclical volatility, ERP is 5% while real long term rates are 2%.  And the risky firm's cost of equity would be 12% (2% + 5% x 2).  Risk aversion increases the cost of capital.  The Fed moving around overnight borrowing markets just isn't going to do much to change those long term borrowing costs.  But, if cash it injects into the economy improves NGDP growth expectations, then ERP will decline, long term real interest rates will rise, and WACC for cyclically sensitive firms will decline.

In fact, if we think about it this way, to the extent that monetary policy affects the cost of capital, it would happen mostly as a result of NGDP growth expectations.  NGDP growth expectations would increase expected corporate profits, increasing share prices, decreasing WACC.  But, this would happen through equity-financed investment, not debt.  And, in fact, that is what we see in the graph above.  During recoveries, market-based leverage declines because the value of equity rises.

We can imagine this in an extreme example where a firm in distress has financial leverage above their optimal target.  If equity becomes so cheap that the firm's enterprise value is dominated by its debt, then WACC would be determined mostly by the firm's interest rates.  In those cases, the firm will be credit constrained, and marginal investments will be limited to generated cash.  So, in that case, lower interest rates will be unlikely to generate leveraged investments, but accommodative monetary policy might lead to a stronger economic recovery in general, which would boost revenues and profits, and for a firm like that, those improvements could lead to a sharp recovery in equity value.  Enough equity recovery might eventually allow them to draw on credit markets again.  But, the recovery plays out in the value of the equity.

Loose monetary policy is frequently blamed for leading to a build up of risky borrowing.  But, cyclically accommodative monetary policy actually leads to systemic stability as equity financing grows.  If monetary policy is loose in a secular sense - over the entire business cycle - so that it does lead to increased inflation, like in the 1970s, then leverage tends to rise because the de facto rate of tax on corporate earnings is higher, and interest expenses bloated by inflation serve to defer taxes.  So, we might say that loose monetary policy does lead to destabilizing leverage, but this happens through high interest rates, not low interest rates.


  1. Interesting post. I think I agree.

    BTW, New Zealand putting bans on foreigners buying homes. Average house in Auckland $1 million.

    Tyler Cowen tsk-tsks, but does not mention trade deficits and property zoning.

    Really, should Aucklanders embrace being forced out of their own neighborhoods?

    1. This calls for one of Tyler's posts where he thinks through the ramifications of something.