Warren Buffett: You don’t need
The end of an era of low interest rates finally seems to have arrived. After dropping to zero during the 2008 global financial crisis, interest rates gradually reached 2.25% in 2018 before falling back to zero in 2020 in response to the Covid-19 pandemic. Now they are back at 2.25%, but the Federal Reserve is very likely to raise them again due to inflation nearing a 40-year high and recent hawkish comments from the central bank. .
As a result, the debt quickly becomes more expensive. It also becomes more risky since the potential for an economic downturn means investors could find it more difficult to service ongoing interest payments.
Investing with debt
In my opinion, it is never a good idea for anyone to use borrowed money to invest in stocks. This may mean that you have less opportunity to hold stocks during the worst bear markets, as you may need capital to pay debt service charges or pay off loan balances. Selling stocks at their lowest level means losses crystallize before potential rallies.
With the S&P 500 currently experiencing heightened volatility, it is arguably even more important for investors to use only cash, rather than debt, to invest in stocks at this time. This can be somewhat difficult since the stock prices of many companies have fallen to levels that suggest they offer wide margins of safety. It could also encourage some investors to use borrowed money to invest in a variety of stocks while they are at low levels or to leverage the cash they have in an attempt to boost their returns.
But with the average bear market having previously lasted 10 months and the current bear market being about three months old, investors should brace themselves for a relatively long road to recovery.
This negative view of borrowing money to invest has already been discussed by Berkshire Hathaway (BRK.A, Financial) (BRK.B, financial) CEO
warren buffet (Trades, Portfolio), who said, “I’ve seen more people fail because of booze and leverage – leverage being borrowed money. You really don’t need leverage in this world. If you’re smart, you’ll make a lot of money without borrowing.
Corporate debt levels
Buffett’s advice could also be applied to the corporate world. Businesses have become somewhat accustomed to being able to borrow at exceptionally low rates in recent years. In some cases, they have borrowed excessively, so their interest coverage ratio, that is, the number of times interest payments on debt are covered by operating profit, is relatively low.
Due to an uncertain economic outlook, some sectors could experience a squeeze on revenues at the same time as their debt interest payments increase. This can mean that their profits are dropping at a relatively rapid rate, and in some cases they might struggle to pay down their debt on a regular basis.
Of course, modest leverage is perfectly acceptable in the corporate world. But as with company valuation, investors should look for a margin of safety when investing in leveraged companies. Otherwise, they could end up experiencing lackluster portfolio returns as increasingly hawkish monetary policy likely kicks in.