In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive

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"Real Rate Shock Hits CEOs as Borrowing Costs Impede Recovery

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By Bryan Keogh

May 13 (Bloomberg) -- The highest inflation-adjusted borrowing costs since the 1980s are hindering U.S. companies’ ability to build their businesses.

Customers of Airgas Inc. are reducing purchases of industrial gases such as nitrogen and acetylene because of rising real interest rates, said Chief Executive Officer Peter McCausland. Real rates account for inflation or deflation.

“There is no question” high real rates have aggravated Airgas’s sales decline, he said in an interview.

The climb in rates “really reflects a risk aversion,” said David Rickard, chief financial officer of Woonsocket, Rhode Island-based CVS Caremark Corp. “People are afraid to lend.”

Annualized consumer prices fell by 0.4 percent in March, the first decline in 54 years, and Treasury yields jumped to a five-month high. That pushed real investment-grade corporate borrowing costs to 8.34 percent, the highest level since 1985, according to data compiled by Bloomberg and Merrill Lynch & Co. Price declines accelerated in April to 0.6 percent, according to 28 economists surveyed by Bloomberg.

Rising real yields may deter companies from borrowing to invest in new products or factories because deflation will erode cash flow and make it harder to service debt, said John Lonski, chief economist at Moody’s Capital Markets Group in New York.

Deflation Hurts

“That’s almost guaranteed to delay an economic recovery and perhaps very much risks intensifying the current economic slump,” Lonski said in a telephone interview.

Deflation hurts businesses in two ways. First, it suppresses sales. When prices are falling, buyers have reason to delay purchases and wait for a better deal.

The second way deflation hurts is by increasing real interest rates, making borrowing more expensive. A $100,000 loan at a 5 percent rate with 2 percent deflation translates into a real yield of 7 percent. When prices are going up, the opposite happens. If inflation is 2 percent, the real rate on that loan is 3 percent.

“Deflation hurts borrowers and rewards savers,” said Drew Matus, senior economist at Banc of America Securities-Merrill Lynch in New York, in a telephone interview. “If you do borrow right now, and we go through a period of deflation, your cost of borrowing just went through the roof.”

The last time Americans experienced deflation was when former President Dwight Eisenhower resided in the White House and the Disneyland theme park first swung open its gates in Anaheim, California. The Consumer Price Index declined for 12 straight months beginning September 1954.

Great Depression

The most severe period of deflation in the 20th century happened during the Great Depression, when prices fell 27 percent from the end of 1929 to 1933, causing companies to stop investing and pushing the unemployment rate to about 25 percent. Federal Reserve Chairman Ben S. Bernanke, who studied the Great Depression extensively and published a book on the subject, has said deflation can be more damaging than too much inflation.

“In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive,” Bernanke said in a November 2002 speech at the National Economists Club in Washington. “Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.”

Sticker Shock

Surging refinancing costs are forcing Energy Transfer Partners LP to cancel or avoid pipeline projects that don’t offer returns above 20 percent, Chief Financial Officer Martin Salinas said in an interview. Debt yields have been 2 to 3 percentage points higher than what the Dallas-based company has been used to, he said.

Energy Transfer, the third-largest U.S. pipeline partnership by market value, in April raised $650 million for capital expenditures and to repay bank debt by offering investors a 9 percent interest rate on 10-year bonds, Bloomberg data show. While 0.7 percentage point lower than what the company paid for similar debt in December, the coupon was 2.3 percentage points higher than an offering a year earlier.

“There is definitely some sticker shock,” said Salinas. “We can’t build the project if we can’t cover our cost and get a return on it.”

While the gap between investment-grade bond yields and rates on similarly maturing Treasuries narrowed 158 basis points in the past two months, a jump in benchmark yields and deflation erased most of the improvement, meaning real rates are still near their highest levels since 1985.

Going Up

“Real interest rates are going up,” said McCausland of Radnor, Pennsylvania-based Airgas.

Yields on the benchmark 10-year Treasury soared to 3.34 percent on May 7, the highest since Nov. 18, from a record-low 2.06 percent at the end of 2008. The Consumer Price Index fell an annualized 0.4 percent in March, and economists surveyed by Bloomberg forecast a 0.6 percent drop for April.

That would put real yields on investment-grade bonds at 7.91 percent last month compared with 8.34 percent in March, the highest since April 1985, five months after “Morning in America” reelected Ronald Reagan to a second term as president. Companies paid nominal rates of 12.1 percent and inflation ran at 3.7 percent for a real yield of 8.44 percent.

Dealing with inflation back then was less tricky than the current problem because the Fed can only lower its target lending rate to zero, said Matus, who has covered the economy for 13 years and is a former monetary policy official at the New York Federal Reserve Bank.

Double Whammy

“There is a limit to how you can adjust your policy to accommodate deflation as opposed to inflation,” he said. “If you have inflation, you know the Fed can handle that.”( NB DON )

The drop in consumer prices is a “double whammy” for retailers, said Patricia Edwards, a retail analyst at Storehouse Partners LLC in Bellevue, Washington. That’s because consumers cut spending and the quality of products they buy, meaning lower prices and sales. “For those who don’t have their funding nailed down, that’s where the hurt is going to be,” she said.

CVS, the largest U.S. drug-store chain, has been relying on short-term commercial paper to finance the construction of new stores after the long-term sale lease-back market it typically used for the investments “disappeared” in October 2008, Rickard said. Companies learned the risks of relying too heavily on commercial paper after the market froze in September 2008 following the collapse of Lehman Brothers Holdings Inc.

Muddling Through

When the sale lease-back market began to recover toward the end of 2008, nominal interest rates of about 14 percent were “too much to saddle us with for 20 to 40 years” on $600 million of needed financing, Rickard said.

“I deferred that financing and we muddled through using commercial paper,” Rickard said. “As people gain more confidence I believe real interest rates will begin to come down and we will get -- not back to where we were in June, July, August of 2008 -- but closer to there than we are today.”

High real rates are worsening already plunging corporate profits, which is the biggest reason for slowing investment, said Dominic Konstam, head of interest-rate strategy in New York at Credit Suisse Group AG. First-quarter profit at non-financial companies in the Standard & Poor’s 500 index fell 35 percent from a year earlier.

“Clearly having high real rates doesn’t necessarily help profitability and the rolling over of debt,” he said. But “it’s of secondary importance rather than primary importance.”

While companies may focus on nominal rates and revenue, higher real yields make projects less economical and slow the growth rate of investment in the economy, Matus said.

Projection Downgrades

Economists downgraded their projections for a recovery from the deepest U.S. recession in half a century, now seeing the jobless rate exceeding 8 percent through 2011, according to the median forecast of 78 economists in a Bloomberg News survey taken from May 4 to May 11. Those estimates were lowered following a two-month rally in bond and stock markets on speculation the economy may be out of recession soon.

Unemployment will average 8.5 percent in 2011 after a 9.6 percent rate next year, higher than previously expected, the survey showed. The economy may expand 2.8 percent in 2011, less than estimated last month, after a 1.9 percent rise in 2010.

Fighting deflation remains a priority for Bernanke. While a Fed governor in 2002, Bernanke earned the nickname “helicopter Ben” when inflation fell to as low as 1.1 percent and he warned of the severe consequences of deflation. He said the U.S. could ramp up its dollar printing presses to arrest a slide in consumer prices, figuratively dropping money from a helicopter to increase liquidity.( NB DON )

Money Injections

“Prevention of deflation remains preferable to having to cure it,” Bernanke said in the National Economists Club speech. “If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”

Bernanke told Congress last week that a “relapse in financial conditions would be a significant drag on economic activity and cause the incipient recovery to stall.”

The U.S. has pledged $12.8 trillion to restore the financial system since rising defaults on subprime mortgages began to saddle financial companies with losses, and the U.S. money supply grew at the fastest pace since 2001.

After dropping its target lending rate to about zero, the Fed said it would buy as much as $300 billion of Treasuries to lower rates, known as quantitative easing. That effectively allows the central bank to print money to reflate the economy.

Spiraling Inflation

Economists and traders are growing concerned that unprecedented U.S. government spending and Fed easing will cause deflation to swing to spiraling inflation as the economy recovers from the recession. The difference between rates on 10- year notes and Treasury Inflation Protected Securities widened to 1.54 percentage points yesterday from near zero at the end of 2008, reflecting growing inflation concerns.

The deflation witnessed so far may be attributable largely to the drop in energy prices as the price of oil fell from a record $147.27 a barrel in July 2008 to $32.40 five months later. The core consumer price index, which excludes more volatile energy and food prices, rose an annualized 1.8 percent in March.

Until inflation does start to surge, companies are still dealing with the opposite phenomenon: declining prices and rising real rates. The Fed will have to buy more Treasury and mortgage bonds to keep company and consumer rates low, Lonski said. The Fed has bought back at least $92.2 billion of Treasuries, 31 percent of the total it committed to purchasing through September. That gives the central bank room to maneuver, Lonski said.

Conserve Cash

Car-rental company Hertz Global Holdings Inc. expects its interest expense to jump by $100 million to $150 million a year and is operating fewer vehicles to conserve cash, which may endanger the Park Ridge, New Jersey-based company’s market share, Chief Executive Officer Mark Frissora said.

Banks “aren’t loaning money, period,” he said in a May 5 interview.

Sara Lee Corp. Chief Executive Officer Brenda Barnes is countering higher interest rates by slashing other fixed costs and eliminating any “waste” in spending. A cost-cutting program announced in November will save the Downers Grove, Illinois-based frozen-cake maker more than $250 million by June 2011, she said during a March 7 conference call.

“It allows us to go to market and still meet our plans,” Barnes said. “Without that we’d be struggling more.”

To contact the reporter on this story: Bryan Keogh in New York at bkeogh4@bloomberg.net"