Through the windshield: rate hikes and borrowing costs for investment grade companies

Nine rate hikes later – what has been the impact on investment grade borrowers?

We look through the lens (windshield, perhaps) of a single manufacturer, John Deere, builder of the green and yellow tractors, ride-on mowers, combines, road construction and forestry equipment, as well as sometimes-banker to its customers. With a market value of US$119 billion, one-year equipment sales of over US$50 billion, a financing arm with a portfolio of circa US$40 billion and a presence in most major economies, Deere remains a single tile in the grand mosaic of the economy. Nonetheless, its experience can perhaps reveal something about the challenges facing central bankers wielding blunt tools.

A financial detective looking for interest rate impact would find clues within borrowing costs, interest earned on cash balances, pension commitments and the indirect effect of the impact on the company’s customers.

Deere’s financial reporting calendar doesn’t exactly match the timing of Fed rate hikes but, in the 12-month period ending 30 April 2023, during which five of those hikes occurred, Deere disclosed that rising rates cost its financing arm US$42.7 million after tax compared to the prior year. Deere generated approximately US$3.6 billion of finance and interest income from that business, up over US$100 million from the previous year, but less than it would otherwise have been. That US$42.7 million (say US$55 million pre-tax) compares to a recurring cost base of just over US$42 billion over the same period. To put it another way, the impact of the Fed’s action on the financing arm was just over one-tenth of one percent (.0013) of John Deere’s regular costs.

The finance portfolio is managed as a ‘match-funded book’, meaning that when Deere makes a loan for three years, it also arranges the funding of that loan for three years. It therefore has a very good idea of what the return will be and has no further reliance on funding markets. Overall, rate hikes have not impacted this part of the business from the perspective of how much they earn on their portfolio. But what about the actual borrowing costs of the company – money borrowed for its own use, not for lending out to customers?

Bond market participants and central banks tend to look at borrowing costs in relation to underlying government bonds. Looking at the cost relative to government bonds helps to understand whether a company is being put under more financial stress. Looking at Deere’s cost relative to the government bond cost for the period 30 April 2022 to 30 April 2023, it appears that Deere’s cost dropped across all maturities of borrowings, by between circa 0.05% and 0.30% depending on which part of the maturity profile one chooses.

What about Deere’s equipment sales? Surely when rates go up, the economy slows and demand should fall? Well, like these other measures, we cannot answer the question of whether sales were weaker than they would otherwise have been, but we can clearly see that the result was not disastrous. Deere’s reported equipment sales and servicing revenue for the 12-months ending April 2023 reached roughly US$55 billion, which was an increase of nearly 33% from the 12 months ending April 2022.

The reader may by now be detecting a pattern. Deere also earned a lot more on its huge cash balances than it did before rate hikes began. Moreover, its pension plan is in better shape than it had been- even adjusting for the $1 billion the company contributed to the plan during the year.

Deere’s results have been very robust, quarter after quarter – this includes a period following the implementation of a new union contract where there were extraordinary supply chain problems. It is possible that, without the rate hikes, this performance would have been even stronger. And it is plausible that the effects of the hikes are still meandering through the various channels of the economy, where they will come to roost at a future date.