Increasing interest rates have always been a double-edged sword.
On one hand, the reason the US Federal Reserve is increasing its benchmark interest rate (currently at 3.75 – 4.00%) is that they want to bring down inflation. And when inflation does finally ease, both individuals and businesses can heave a sigh of relief knowing that prices of goods and services are kept under control.
On the other hand, an increase in interest rate also adds immediate cost for many businesses that are borrowing. This is one of the reasons why we have seen the stock prices of many strong companies declining this year, even though their business is still relatively strong.
When interest rate increases, companies that borrow money will incur higher borrowing costs. With all things being equal, this will eat into their profits and valuation.
Credit Used To Be Cheap
Ever since the global financial crisis, global interest rates have been low. Low interest rates, which used to be a weapon that central banks can use to help spur growth in the economy or combat recession, started becoming a norm for the financial world.
Low interest rates help spur spending and investing. For example, consumers are encouraged to borrow and buy more expensive homes because low interest rates meant lower monthly mortgage repayments.
Similarly, businesses are also encouraged to borrow to fund their expansion, even when they have no need to borrow. For example, this article written in 2021 published by The Washington Post explained why Apple decided to borrow $14 billion even though it has about $200 billion in cash and marketable securities.
Note: The TL;DR is that it’s cheaper for Apple to borrow money, enjoy tax deductions on the interest they pay on the loan, and use the money to buy back shares.
Amazon too borrowed money that it doesn’t need to buy back shares, even though it also has tens of billions in cash.
When Borrowing Is Expensive, Does It Make Sense To Become A Lender?
When interest rates were low, companies borrowed money even though they had cash savings they could have used.
Now that interest rates are high, does it make more financial sense for companies to become lenders instead?
Think about it. When interest rates are low, investing a company’s excess savings in a money market fund that pays us less than 1% p.a. won’t give us much returns.
For example, a company with $200,000 in savings will make less than $2,000 a year, or less than $200 a month. It’s decent, but not to the point that an SME owner with spare savings may think it’s worthwhile to invest. With interest rates so low, the logical thing would be to borrow money and hold on to cash savings to give the business greater flexibility.
However, with interest rates increasing, the reason to lend instead of borrow strengthens. At 4% p.a., the same $200,000 can give us an annual income of $8,000, or about $667 a month.
Investing Is Not Risk-Free
It’s worth pointing out that while keeping your savings in a bank account is free, investing in money market funds, sometimes used interchangeably with cash management accounts, isn’t risk-free.
As pointed out in a previous article we wrote, an increase in interest rates may cause a decline in the short-term value of the money market funds/cash management accounts. During this period, if a company needs to withdraw funds at the point in time when there is a decline in the value of their funds, they may suffer an investment loss.
As such, similar to retail investors, it’s better for companies to invest excess savings that they do not need in the short-term if they wish to make higher returns.
What we observe is that current rates for cash management accounts that invest in a mixture of money market funds and short-duration bonds are giving returns of between 3 to 4% p.a.
With borrowing (cost of capital) being so high today, companies including many SMEs may look towards becoming lenders instead of borrowers. Being a lender means making the most of the opportunity to earn decent interest on savings in our business account that we don’t need.
Need Financing Support During This Period?
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