Borrowing costs for investment-grade corporates have ballooned in the past 12 months or so. In the US, the five-year BBB corporate bond yield is back to more than 5 per cent, a level not seen since 2009.
On average it was below 2.75 per cent between 2012 and 2018, and below 1.6 per cent in 2020-21. This is a major change in the environment for both companies and individuals.
Markets are still working through all the implications of a higher cost of capital. We describe them as the "three Ds": derating, downgrades, and debt refinancing.
Derating first. The most obvious example of risk here is in the sector that has been the most beloved in recent years: technology.
After a brief spell out of favour, the tech sector has rallied strongly this year to again become the darling of investors.
In our view, there is little fundamental logic to the rally. Problems in the banking sector on both sides of the Atlantic have sent investors running back to the winners of the past decade in search of familiarity, and the safety of companies with net cash on the balance sheet.
The real lesson of the crisis in mid-sized US banks is the reminder that investors need to be very wary of assets purchased or built with, or business models reliant on, unsustainably low interest rates and low cost of capital.
We would caution that derating risk is not dead, just sleeping. In the context of normalising bond yields, tech stocks still look expensive to us. Tina (the acronym for "There is no alternative") is no more. There is an alternative.
Downgrades, the second D, should be less of a surprise, but no less unwelcome, as a recession in the US (at the very least) looms large.
The minutes of the March meeting of the Federal Reserve revealed concerns among senior officials over the potential for the turbulence in the banking sector to end up tilting the US economy into a recession before the end of the year.
Investors need to remember how earnings in many parts of the market are still well above historic averages, boosted by the exceptional conditions of 2020 and 2021. The process of normalising earnings expectations will take a while and could be uncomfortable for some.
This brings us to the third D: debt refinancing. Last but by no means least, in such precarious markets, a company’s ability to refinance its debt can be an incredibly useful indicator of how well it is likely to ride out the storm.
It is easy to argue that in this environment you should just sell any company where financial gearing is an inherent part of the business model, for example financials or infrastructure. But we disagree with this, and here is why.
Total debt is only one side of the story. Investors should also consider when the debt will mature and what it will cost to replace – that is, what will be the likely cost of refinancing.
As a general rule, we would say that refinancing risk is higher for European companies, which tend to have shorter-dated and less fixed-rate liabilities than US ones.
For banks it is the other way around. US banks struggle to price up their longer-dated, fixed-rate assets (their loans) to match the rising costs of their liabilities (their deposits).
In Europe, where bank loans tend to be shorter-dated, credit quality is probably a greater risk than the spread on interest rates.
To illustrate the point, take two companies in a sector we like: infrastructure. One, a US-regulated utility that we own, and the other, a European telecom tower company, which we do not.
The US-regulated utility has long-dated debt with a weighted-average maturity of more than 20 years, with an average coupon (3.9 per cent) not that far off their marginal cost of funding (4.6 per cent).
For what it is worth (not much, judging by recent events in US financials), the S&P credit rating remains investment grade at BBB+.
Meanwhile, the European telecom tower company has an S&P sub-investment grade rating of BB+, with short-dated debt with a weighted-average maturity of less than five years, and a cost of 1.6 per cent, which is likely well below their marginal cost of funding.
Both of these companies are expected to face rising interest costs in the coming years. But the headwind to earnings, and the much more serious risk of being unable to refinance at all, are going to be much less of a problem for the US-regulated utility than for the European telecom tower.
Dependable infrastructure investments like the US-regulated entity, with strong, long-dated balance sheets and resilient cash flows, are one way to navigate through the difficult investment climate dominated by the three Ds.
Regulated utilities, particularly in the US, can be regarded as a port in the storm.
And even better, they are not simply defensive assets; they are major beneficiaries of a fourth D: decarbonisation, which requires substantial investment in new and replacement infrastructure in western economies.
They offer the best of both worlds – resilience and growth – combined with very attractive valuation support.
Investors retreating back into their tech comfort zone in these volatile times, we believe, risk missing out opportunities in the real world of physical infrastructure.
Ben Leyland and Rob Lancastle are co-fund managers of the Global Opportunities Fund at J O Hambro
