Tuesday, June 03, 2008

Yield Curve Ball

Investors favoring the small cap and micro cap sectors tend to focus on company-specific issues such as competition or adequacy of cash resources. Macro-economic issues only come into play when gauging demand trends. Those thorny and complex topics like currency rates and yield curves are rarely a hot topic at small-cap investor conferences. The only time interest rates get any attention is when a company needs to borrow money for working capital or an acquisition. Then the relative level of interest rates typically does not matter. Often when small, early-stage companies need money they need money regardless of the price.

As illustrated by the four charts below that show the yield curve at four points in the last ten years - near the beginning of the last bull-market in June 1998, just three months before the 9/11 event that rocked the U.S. financial markets, one year later in June 2002, and then today. Long-term yields remained near 6% until recently when the Fed lowered rates in an attempt to jump start the economy. That same Federal Reserve action has dramatically lowered rates in the shortest terms from a level near 5% ten years ago to just under 2% today.

Generally, this is a boon to smaller companies in particular since it is possible to shore up working capital or avoid the issuance of dilutive common stock for acquisitions.

What is of much greater concern is the fact that rates are lower but lending standards have been elevated by several orders of magnitude. Many might argue that there is no credit crisis - only a crisis of confidence. There is plenty of money available to lend, just none for the same borrowers who had been bellying up to the lending trough in the recent past. It is a flight to quality of unprecedented proportions.

The new attitude in the credit market affects smaller companies in a second, more subtle way. As the whole term structure of interest rates declined, investors had to sneak out further on the yield curve to say ten or fifteen years in order to get better yields on their investments. Exotic securities held up by mortgages and student loans seemed like a smart answer. Unfortunately, the market to trade such securities has vanished - part of that same exodus to quality. The loans underlying these securities are not in default. Interest payments keep coming in. However, they are not longer marketable and no long enjoy that berth just under the cash and equivalents line on the balance sheet. A number of companies have recently reported a shift of short-term investments into the long-term portion of the balance sheet.

For smaller companies that often rely on cash resources to finance development, the liquidity situation could indeed be a crisis situation. We are looking closely at all balance sheets and cash usage patterns to avoid or at least anticipate a “yield curve ball.”
Yield Charts from BondsOnline.com

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