the Demand for Debt and Equity Capital

Interest rates play a major role in the pricing of securities and the allocation of capital by businesses and investors. This applies to both debt and equity capital and is therefore of utmost importance to investors. As an investor, you need to understand this role.

We tend to think of interest rates merely as what we earn on debt securities such as bonds, money market funds, CDs and interest-bearing bank accounts. But they affect us in many more ways than those which are readily apparent.

Interest rates are a major determinant in the demand for capital. As capital is allocated on a supply and demand basis, increases in lending rates will decrease the demand for borrowed funds and, indirectly, the demand for equity capital because the return investors require on equity capital also rises with interest rates. This reduces capital investment which leads to decreased economic activity in the short term and impairs businesses’ future productive capacity. Of course, decreases in rates have the opposite effects.

The allocation of equity capital applies not only to capital raised by the sale of stock, it also applies to the use of retained earnings. When firms invest in new projects, they attempt to maintain a constant balance between debt and equity. However, if new projects are not undertaken because prevailing interest rates cause the combined cost of debt and equity to exceed the expected return on those projects, investors will have fewer opportunities to lend money and retained earnings may not be reinvested.

Retained earnings generally are not kept in cash or cash equivalents, firms usually put retained earnings to work earning stockholders an acceptable rate of return. However, when no new projects are undertaken due to high interest rates, cash can start to accumulate, then businesses are faced with the dilemma of deciding whether to sit on the cash, causing stockholders to suffer a low return on their investments, or paying the excess cash out as dividends. Corporations pay dividends out of after-tax earnings and stockholders must pay taxes on the dividends, then they must find opportunities to reinvest what is left after paying taxes. It may appear that the IRS is the only winner in this scenario, but even they are losers in this game, as decreased economic activity and the impairment of future productivity tends to reduce their overall receipts.

Supply and demand are a two way street. Interest rates can also rise and fall with demand. From this perspective demand drives interest rates. When businesses demand more debt financing, the cost of debt required by investors will increase. But the demand for additional debt will become less as interest rates rise and a point of equilibrium will eventually be reached, at which the demand for debt will remain constant until some economic force causes it to change.

Economic forces that can cause the demand for debt to change include such things as actions by the Federal Reserve designed to affect rates, a change in economic forecasts, a change in investor sentiment, geopolitical turmoil, etc. Actions of the Federal Reserve would be a good example of interest rates driving the demand for debt. Or a gloomy economic forecast can cause the demand for debt to decrease, thus precipitating a decrease in rates.

The Risk-Free Rate & Risk Premiums

The cost of debt consists of a risk-free rate of return plus various risk premiums demanded by lenders. Very short-term U.S. Treasury bills are used as a proxy for the risk-free rate, r*. Short-term T-Bills are the safest debt instrument in the world and, as they are so short in duration, they are virtually net of inflation. The risk-free rate is used often in finance, as all investments are priced with the risk-free rate as the basis.

The risk premiums that investors add to the risk-free rate to determine the rate of return they require for a given debt security are: inflation (IP), liquidity, (LP), maturity (MP), default (DP) and call (CP). Thus the rate of return required by investors is the sum of the risk-free rate and these premiums:

r = r* + IP + LP + MP + DP + CP

The inflation premium reflects investors estimates of the future level of prices and thus the future purchasing power of interest payments and the principal that will eventually be returned to them. 28-day T-Bill rates include a minuscule inflation premium under ordinary economic conditions. 15-year Treasury bonds carry a very significant inflation premium. As investors tend to estimate future inflation by recent history, inflation premiums often over- or underestimate inflation.

The liquidity premium compensates investors for holding debt securities that cannot easily be sold at a fair value. U.S. Treasury securities are very liquid and therefore carry little or no liquidity premium. The bonds of other issuers, both public and private, have varying degrees of liquidity and their liquidity premiums vary accordingly.

The maturity premium compensates investors for their exposure to interest rate risk. The longer the time to maturity, the greater a bond’s price sensitivity to interest rates. A small change in interest rates will have a very significant impact on the value (market price) of bonds with a long term to maturity. The longer the term to maturity, the greater the maturity premium. A bond’s duration. rather than the actual term to maturity, provides an approximate measure of a bond’s interest rate sensitivity.

The default premium is demanded by investors as compensation for their exposure to the risk of the issuer defaulting on its debt. Default is not an issue with U.S. Treasury debt. Other debt spans the spectrum from very high quality to highly speculative, a.k.a. junk. As quality decreases, default risk premiums increase.

Any bond that is callable will carry a call risk premium. This compensates investors for their exposure to risk of bearing the cost and inconvenience of having bonds they are holding called before maturity. One reason for calling a bond is falling interest rates. When bonds are called for this reason, investors lose remaining coupon payments at the higher interest rate and must reinvest their principle at the lower rate.

Covenants in bonds’ indentures can result in other risk premiums being required by investors. But the five premiums listed above generally cover all of the risks of plain vanilla issues.

The Term Structure of Interest Rates

Under ordinary circumstances, bonds with longer terms have higher effective rates, which is attributable to interest rate sensitivity. This results in an upward-sloping yield curve as shown below. Yield curves are developed from the yields on bonds of similar credit quality. The yield curve will shift up or down with changes in quality and bonds with low ratings will plot higher than bonds with high ratings, reflecting the default risk premium. The shape of the yield curve is referred to as the term structure of interest rates .

Occasionally, long-term rates will drop below short-term rates, resulting in an inverted yield curve, which sweeps down to the right. This condition usually will not persist, as investors ordinarily require a lower maturity premium for bonds with shorter terms. In such cases, short-term rates can be expected to fall, thus returning the yield curve to its usual upward-sloping shape. An inverted yield curve often occurs just prior to a recession and has come to be considered as a pretty good predictor of recessions, although the accuracy of such predictions is not perfect.

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Section Intro Next Section