Zero Interest Rate Phenomenon

The consequences of moving from ZIRP to HIRP

Photo by Kanchanara on Unsplash

I remember thinking during the meme stock mania of 2021 that we would only appreciate in hindsight just how crazy this period was. It is hard when you are living through a market mania to process the events in real time. When one of my stocks got mentioned on a WallStreetbets page and went up like 25% in a day, I recall thinking how much I would regret selling some of the stock if it went up as much as GameStop did when it went parabolic (see below).

Very quickly, my conservative value investor brain kicked in and asked the logical question: would I buy the stock at its current position size if I were buying the stock for the first time today? The answer was no and I trimmed it. Thankfully for my own sanity, the stock didn’t go up 3x after I sold it. But for a brief moment I really did consider HODLing (holding on for dear life for those of you who are not familiar with that lovely acronym).

There is now a movie about this wild time so at least it will be forever immortalized on the big screen. However, the story that has yet to be told is regarding the full extent of the carnage that years of zero interest rate policy (the OG definition of ZIRP) will eventually unleash on financial markets. Interest rates represent the price of money and when interest rates are 0%, money is essentially free and people inevitably do totally crazy things with free money. Or, they simply put money to work in exchange for yields that only make sense when the opportunity cost of holding cash is 0%. What made sense then certainly doesn’t make sense when you can get 5% from a 12-month CD.

With that as the context, I want to propose a new definition of zirp (using lower case to distinguish it from the more common definition): zero interest rate phenomenon. What I am referencing are investments that were made during the time when hundred dollar bills were falling from helicopters but that are going to suffer big losses if they are ever sold (in the form of permanent impairment of equity capital) or when the lenders have to write down the value of loans that are impaired. There are plenty of zirp darlings that have already taken their medicine. While companies whose stocks benefited from meme mania, such as Gamestop and AMC, are still around, their stocks are way down from where they were. Electric vehicle companies that were going to put all of the legacy auto and heavy duty truck makers out of business? Lordstown went BK and Nikola, which famously rolled a truck down a hill hoping to make people believe they had a working prototype, trades for about $1. NFTs? Mostly worthless. Dogecoin? Still around but is way down from its high and crushing speculators’ dreams. Last but not least, let’s just say that former SPACs have become a universally hated group of companies that have destroyed billions in shareholder wealth.

What do all of these companies have in common? Speculative frenzies can be aided and abetted by loose monetary policy. In this case, by leaving interest rates so low for so long, the Fed did more than just facilitate speculation. In reality, the Fed planned the caper, ran into the bank, carried out the gold bars and drove the getaway car. While we can never know for sure how much the Fed contributed to some of the above manias and inevitable crashes, it is fair to say that it enabled a lot of delusional behavior and created demand for a whole host of assets classes whose success was simply a zero interest rate phenomenon.

From ZIRP to HIRP

A logical question to ask is: why is this relevant now? As fast as markets and asset prices move today, all of the above might seem to be ancient history. Inflation has come down, unemployment is low, and the US economy seems to be weathering higher rates pretty well. Plenty of people have eloquently scolded the Fed for its ZIRP policy but with rates where they are now, why revisit this topic? My premise remains that the move from ZIRP to HIRP (higher interest rate policy) has yet to claim all of its victims. We saw what happened to Silicon Valley Bank last year but the carnage in the regional banking sector was limited and seems to have mostly abated. Meanwhile commercial real estate owners, especially investors who own equity in office buildings, are likely to have to face the music—in the form of higher cap rates and lower occupancy—at some point in the near future. But everyone knows that, right?

Where are there some non-obvious, almost hidden pressures that will eventually bubble up to the surface? In an environment where the promise of AI has rekindled animal spirits that seemed to have gone dormant in 2022, it is easy to forget that companies of all sizes are dealing with the reality that the costs of financing themselves is much different today than it was three years ago. My sense is that the rise in interest rates is going be most acutely felt by smaller companies, especially those that already struggle to generate consistent free cash flow.

HIRP and Zombification

I would expect this to be a slow moving train in most circumstances because many companies were smart enough to lock in fixed rates for a long period of time when the money was essentially free. But now that we have moved from 0% rates to HIRP (higher interest rate policy), the entire investing landscape—as it pertains to putting money to work today or in the near future—has changed. Cash is a legitimate alternative to stocks and bonds. Treasuries are producing a nice yield. Real estate cap rate expectations have been totally reset. The free money for VC-backed companies and founders has dried up to some extent. My guess is that the hurdle rates for internal investments, M&A and even buybacks within public companies has gone up materially. And I don’t think this return to more “normal” rates is likely to change particularly fast.

I am not crazy enough to believe that I know if the Fed’s rates go up or down from here but I would submit that there is a high probability that we are not going to re-visit the ZIRP lows in rates, absent another pandemic or a GFC-like event, of course. (By the way, if one of those do occur, the second the Fed puts out a statement regarding “unlimited liquidity” just buy the most speculative assets possible, using as much leverage as your counterparties will allow. You will be glad you did.) If that is the case, what are the implications that public company investors should be considering now? In other words, assuming that HIRP is going to have a significant impact on investments made under the influence of ZIRP—as well as on go-forward financing costs—what might we see more of going forward?

Zombies, lots and lots of zombies. Not the ones who chase you through a graveyard late at night but companies whose capital structure and debt stack made sense during ZIRP but are going to be paralyzed—if not put out to pasture—with high yield rates where they are today. Plenty has been written about the potential for private equity sponsor-owned companies who were fortunate enough to carry 5x to 8x leverage when debt was cheap to become zombies. (Recall that a lot of private credit capital has been used to help fund buyouts.) But I think the same is true for public companies, especially smaller ones who banks are not exactly excited to lend to, even if they did not take on excessive leverage when money was basically free.

Take Mercer International (Ticker: MERC), for example, a ~$670mm market cap pulp and wood products company based in Canada with about $1.6 billion in debt as of the last quarter. The company recently issued $200mm in 2028 senior notes at 12.875%. I dug into the company’s 10-K to see the rate at that Mercer was paying on its Canadian facility, the one the notes were used to pay off. For 2022, that number was 6.034%. The new debt is over 2x the cost of what it was replacing. Further, here is what the company’s previously issued senior notes look like (from CapIQ):

The new debt costs 2.5x what the 2029s were issued at. The company was paying about $19mm per quarter in interest and now that is about $27mm. Mercer has a few years before the big slugs of debt become due. But if you mark all the notes to market (a 12.875% cost of debt), interest expense on the notes alone would be more like $150mm. For a capital intensive business that can be impacted by swings in commodity pricing, a $70mm reduction in free cash flow (ignoring any tax shield for the moment) is a huge hit.

I am not trying to pick on Mercer. There are probably tons of companies out there who took on a dollar amount of debt that was manageable when rates were lower and allowed for some free cash flow generation. If rates stay where they are and companies are forced to refinance or issue new debt, there is a real possibility that discretionary cash flows are going to dwindle. Will these companies be able to invest in growth and maintenance CAPEX in order to juice the top line? How will they pursue high return acquisitions? Will there be pressure on internal SG&A and R&D spending? If so, these companies will essentially become zombies that have limited resources to facilitate growth, super expensive debt and no ability to issue equity because their stocks prices are depressed. Another way to look at is that if the cost of debt for MERC is almost 13%, the cost of equity is probably in the high-teens.

Microcap stocks have already been basically left for dead. As mentioned in previous posts, the Russell Microcap index has been the worst performing index over every long time period. Some people might look at the impending zombification of smaller companies and these awful relative returns as a sign that the companies in the space are all broken and are essentially uninvestable. On the contrary, our research suggests there is an opportunity to carefully pick through the wreckage to find real businesses that probably have no business being public anymore. And, HIRP might be just the catalyst that puts some companies into play that wouldn’t have considered trying to compound outside of the public eye previously. Or, it may be the case that perfectly decent small companies with high return growth investments will not have easy access to capital to source from their traditional investor bases. These companies are going to need capital, whether as public companies or private ones. As such, someone with the right investors and the proper fund structure and approach (like Devonshire’s, for example) is likely going to have a very fertile hunting ground. Twitter DMs are open if such a strategy is of interest.

Perpetually coming up with new acronyms,

Ben Claremon