The end of an era of low interest rates finally seems to have arrived. Having plummeted to zero during the global financial crisis in 2008, interest rates gradually reached 2.25% by 2018 before falling to zero again in 2020 in response to the Covid-19 pandemic. Now they stand at 2.25% again, but it is very likely the Federal Reserve will increase them again due to inflation being close to its highest level in 40 years and the central bank's recent hawkish comments.
As a result, debt is rapidly becoming more expensive. It is also becoming riskier since the potential for an economic slowdown means investors may find it more difficult to service ongoing interest payments.
Investing with debt
In my view, it is never a good idea for any individual to use borrowed money to invest in shares. It can mean you have less scope to hold stocks through the very worst bear markets since you may need capital to pay for debt servicing costs or to repay loan balances. Selling stocks at their lowest level means losses are crystallized ahead of potential recoveries.
With the S&P 500 currently experiencing heightened volatility, it is arguably even more important for investors to only use cash, rather than debt, to invest in stocks at the present time. This may be somewhat challenging since many companies’ share prices have fallen to levels that suggest they offer wide margins of safety. It might also tempt some investors to use borrowed money to invest in a variety of stocks while they are priced at low levels or leverage what cash they do have in an attempt to increase their returns.
But with the average bear market having previously lasted for 10 months and the current bear market being around three months old, investors should prepare themselves for a relatively long path to recovery.
This negative standpoint on borrowing money to invest has previously been discussed by Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) CEO Warren Buffett (Trades, Portfolio), who said: “I’ve seen more people fail because of liquor and leverage — leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.”
Corporate debt levels
Buffett’s advice could also be applied to the corporate world. Companies have become somewhat used to being able to borrow at exceptionally low rates in recent years. In some cases, they have borrowed excessively so that their interest coverage ratio, which is how many times debt interest payments are covered by operating profit, is relatively low.
Due to an uncertain economic outlook, some sectors could experience a squeeze on revenue at the same time as their debt interest payments rise. This may mean their profits fall at a relatively rapid rate and, in some cases, they could struggle to make regular debt repayments.
Of course, a modest amount of leverage is perfectly acceptable in the corporate world. But as with valuing a company, investors should seek a margin of safety when investing in companies that have debt. Otherwise, they may end up experiencing poor portfolio returns as an increasingly hawkish monetary policy likely comes into effect.
