Declining interest rates—particularly in an already low-interest-rate environment—offer a distinct advantage to so-called superstar companies, according to research from Princeton PhD student Thomas Kroen, Princeton’s Ernest Liu and Atif Mian, and Chicago Booth’s Amir Sufi.
“Extremely low interest rates are not neutral for market competition,” Sufi says, “and they may explain why market concentration has been rising.”
Kroen, Liu, Mian, and Sufi draw from a CRSP-Compustat merged data set—focusing on 1980 onward—to measure excess returns for industry leaders in the United States versus the rest, in relation to interest-rate moves. Industry leaders are defined broadly as companies in the top 5 percent by market value in any sector; the researchers also ranked leaders by the top 5 percent in earnings before interest, taxes, and depreciation, as well as revenue. They constructed a portfolio that went long on the industry leaders and shorted the nonsuperstar companies, and then studied its performance in response to changes in the 10-year Treasury rate.
The study demonstrates that the valuations of superstar companies rose, relative to their competition, when interest rates fell. Those valuations were boosted by three key benefits of falling rates, whose advantages built on each other. First, the researchers argue, a decline in interest rates disproportionately lowered borrowing costs for the top 5 percent of companies in any given industry. Next, these companies took advantage of these decreased costs to issue additional debt. Third, this additional debt financing allowed them to repurchase shares, increase capital investment, and engage in M&A activities at a higher rate than non-A list companies.
“All three of these effects also snowball as the interest rate approaches zero,” the researchers write.
Illustrating the snowball in action, the researchers give an example in which the federal funds rate started at 2 percent, and a 10-basis point decline in the rate spurred a 15-basis-point relative decline in borrowing costs for market leaders compared with followers.
The researchers define borrowing costs as the ratio of interest expense to total liabilities, or the average rate of interest paid on a company’s liabilities. When the rate was closer to zero at the outset, that same 10-basis-point decline in the federal funds rate meant a 24-basis-point drop in borrowing costs for superstar companies and a 9-basis-point drop for the rest.
Very low rates are one likely culprit when it comes to the dominance of some companies over others.
The key finding from the research, notes Sufi, is that the interest rates of the leaders fell as rates decreased, whereas the interest rates of the followers also fell but not by as much.
“We don’t have an exact explanation,” Sufi says, “but it could be that investors view leaders as safer and therefore more comparable with the US Treasury. In that case, whatever forces bring down the Treasury also bring down the interest rates of leaders. Followers don’t get as much of this decline.”
When it comes to debt, that 10-basis-point federal funds rate decline, in an already close to zero interest-rate environment, prompted a 5 percent relative increase in debt issued by top companies, as well as a 2 percent boost in property, plant, and equipment as compared with nonsuperstar companies.
This study builds on previous research by Liu, Mian, and Sufi that finds market leaders invest more aggressively than followers in a falling-interest-rate environment, in order to “go for the kill,” as the researchers put it, and stake their claim on more valuable future cash flows. Market followers, at the same time, understand that their higher-level competition will fight harder for dominance in this environment—for example, they may be more likely to target rivals for cash acquisitions—and are discouraged from more aggressive investment. Thus, the productivity gap between leaders and followers widens as interest rates plunge.
Ultimately, very low rates are one likely culprit when it comes to the dominance of some companies over others.
As the researchers note: “While low interest rates are generally thought to be expansionary, very low interest rates might also have a contractionary impact on the economy via the rise in market concentration.”
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