Real Rate Shock Hits CEOs as Borrowing Costs Impede Recovery

(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.

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