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Manufacturers: Are You Prepared for the Risk of Higher Borrowing Costs? Blog Feature

By: Michael Guckes, Senior Economist on April 13th, 2022

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Manufacturers: Are You Prepared for the Risk of Higher Borrowing Costs?

Firms that are borrowing on variable-rate credit to purchase inventory should be strategically considering just how much inventory they want to be holding onto should the interest rate on their debts double in the near future.

Although the below math is all 'back of the envelope' with no complicated modeling involved, the simple financial logic is that markets won't let firms borrow below the inflation rate in the long run. Therefore, leveraged firms need to be working on a tactical strategy to address the reality that the cost of borrowing money will get much higher soon. For the sake of their cash position borrowers need to be prepared before and not after this adjustment comes.

If you attended one of my October 2021 presentations, you would recall my warnings about the risk associated with higher borrowing costs. Those predictions have now become a reality. As of February 28, 2022, the borrowing cost for BBB-rated firms had increased to 3.4%* from 2.4% in Q4 2021. While these rates in absolute terms are low by historical standards, the pace of increasing rates has been extremely quick. This pace could indicate that markets are correcting for recent months in which borrowing costs were well below the inflation rate.

Between early 2017 and the start of the COVID-19 pandemic in March of 2020, the average interest spread or "premium" between BBB-rated bonds and the U.S. Core Inflation Rate was 1.6%. Yet, troubled supply chains over the last two years have disrupted supplies in the face of a strong consumer, as a result, we have witnessed rising prices for goods and services. The March 2022 U.S. Core Inflation reading of 6.4% is nearly 2.5% ABOVE the borrowing cost of a BBB-rated bond. In short, firms are presently borrowing money at a -3% real interest rate.

Assuming the market will correct for this imbalance and return to a 1.6% positive premium would mean BBB lending rates would increase by 4.6% above their current level, resulting in an estimated borrowing cost of just over 8%.

Note: Per the below graph, the BBB rate was reported at 3.9% as of April 1, 2022.

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