Falling Rates and Rising Superstars

Key evidence, “…A decline in interest rates boosts the value of industry leaders relative to followers, and this effect snowballs as the level of the interest rate becomes lower. We now explore mechanism through which industry leaders gain relative to industry followers when interest rate declines. We first explore whether the decline in economywide interest rates such as the 10 year Treasury rate has been associated with a differential decline in the cost of debt financing for industry leaders relative to followers. A stronger pass-through of lower Treasury rates into the cost of debt financing for industry leaders represents another advantage of a low interest rate environment for leaders relative to followers. As before, industry leaders are defined as the largest 5% of firms in each Fama-French industry, measured by market capitalization. We define each firms borrowing cost as the ratio of interest expense to total liabilities, which is simply average rate of interest paid on it’s liabilities. We treat the largest 5% of borrowing costs in the sample as missing in order to exclude any outliers in the data. Figure 6 plots the evolution of the median borrowing cost faced by both leaders and followers, displaying both a clear downward trend and also a stark increase in spreads since 1980. The spread in the 1980s was 31 basis points whereas the spread in the 2010s is 127 basis points.The interest rate spread between market leaders and market followers widened even though the level of interest rate fell considerably. We present estimates of the effect of a decline in interest rates as defined by the monetary policy shocks discussed in Section 3 on the cost of debt financing for industry leaders versus followers. As above, we measure borrowing costs using the average interest rate paid by the firm on all debt. We calculate this as the total interest expense divided by total debt. We exclude the top 5% observed values of borrowing costs, due to the presence of implausibly large values….”

Note this builds off their “Low Interest Rates, Market Power, and Productivity Growth” which argued that low interest rates reduce business dynamism as market leaders gain share as market followers cut investment to a greater degree then they do in face of low rates (attached)

Thomas Kroen, Ernest Liu, Atif Mian and Amir Sufi, “Falling Rates and Rising Superstars,” National Bureau Of Economic Research, October 2021, https://www.nber.org/papers/w29368

Mian and Sufi find that falling interest rates disproportionately help industry leaders, particularly in low rate environments. They find that spreads (borrowing) btw industry followers versus the leaders is stable and the borrowing capacity of leaders growths Mian characterizes it as “snowballs” as interest rates approach 0. They find that as rates go down the market value of leaders rises more than followers (superstar effect) and their borrowing cost (relative to followers) fall. That allows cheaper leverage, buybacks, capex and acquisitions making effect more pronounced. “…we find that falling interest rates boost the relative valuation of industry leaders relative to industry followers, and the relative valuation effect becomes largest as the initial interest rate approaches zero. This result is robust to the use of high frequency monetary policy shocks as a source of variation in economy-wide interest rates. A decline in the interest rate disproportionately lowers the cost of borrowing of industry leaders, who take advantage of the lower cost of borrowing to raise additional debt financing, increase leverage, repurchase shares, boost capital investment, and conduct acquisitions. All of these effects snowball as the level of the interest rate decline; that is, a decline in interest rates has a stronger effect on all of these outcomes of leaders relative to followers when the initial level of the interest rate is already low.The findings provide empirical support to the idea that extremely low interest rates may be a culprit in explaining the rise of superstar firms in the U.S. economy…

The basic dynamic, “…This paper formally investigates the empirical relationship between economy wide interest rates and the rise of superstar firms in the United States using the merged CRSP-Compustat data set from 1962 to 2019. We begin by analyzing the stock market reaction to an interest rate decline for industry leaders versus industry followers, where we define the top 5 percent of firms by value in an industry as “leaders” and the rest as “followers”. We construct a “leader portfolio” that goes long industry leaders and shorts industry followers, and we examine the portfolio’s performance in response to changes in the ten year U.S. Treasury rate (r). We find that the leader portfolio exhibits higher returns in response to a decline in r, and, more importantly, this response becomes stronger, or snowballs, when the initial r is low. We control for the price to earnings ratio as a measure of implied duration, showing that the snowballing effect is not mechanically driven by industry leaders having higher duration. This suggests that lower r impacts relative firm valuations not only through changing the discount rate but also through possible endogenous changes in expected future cash flows that favor the current industry leader – a finding consistent with the strategic competition channel above. Interest rate changes are endogenous to changes in the overall economy, and there is an obvious concern that omitted variables may be responsible for the results. For example, the interest rate decline is naturally correlated with negative news about future demand; if industry leaders have a larger option value on future demand, then the spurious correlation between the interest rate movement and expected demand will lead us to underestimate the true differential impact of the interest rate decline on industry leaders….”
Impact is stronger at lower interest rates, “…Since the impact is stronger at low levels of r, for expositional purposes we always report the predicted magnitude of our estimates at an interest rate of r = 2%. We find that a 10 basis point reduction in r when r = 2% translates into a 0.53 percentage point larger increase in the market valuation of industry leaders relative to industry followers. We investigate the possible reasons and mechanisms that lead to lower rates boosting the relative valuation of industry leaders. We find that a fall in r exhibits a stronger pass-through to the borrowing costs of industry leaders relative to industry followers, and this effect snowballs at lower r. In terms of magnitudes, a 10 basis point decline in r leads to a 14 basis point relative decline in the borrowing cost of industry leaders relative to followers at r = 2%. When the initial r is very close to the zero lower bound, a 10 basis point decline in r leads to a 24 basis point relative decline. Industry leaders take advantage of the lower cost of debt financing. There is a large relative increase in debt issued by industry leaders relative to industry followers, and the book leverage ratio of leaders also increases. The effects of a decline in r on these two financial outcomes also exhibit the snowballing effect: the effect of a decline in r is larger when the initial interest rate is lower. When the economy is close to the zero lower bound, a 10 basis point decline in r leads to a 5.2 percent relative increase in debt issued, and a 1 percentage point relative rise in the leverage ratio for industry leaders. Some of the additional debt raised is used to buy back shares, which also contributes to the rise in leverage we observe….”

“…The final set of results concern the relative real effects of lower interest rates on industry leaders versus followers. These results largely follow the stock market and financial effects described above. We find that a decline in r leads to a relative increase in capital expenditures, cash acquisitions, and property, plants, and equipment (PPE) for industry leaders relative to followers. These real effects, like the valuation and financial effects, also snowball at lower levels of the initial interest rate. The results on investment provide empirical support to the prediction in Liu et al. (2021) that industry leaders respond more aggressively to a decline in the interest rate in order to “go for the kill” to ensure their claim on the more valuable future cash flows. Interestingly, one of the strongest results is on cash acquisitions, which suggests that industry leaders may be more likely to target their rivals when interest rates fall from very low levels. Overall, our results have important implications for the broad literature on persistently low interest rates (or r*) and their implications for the macroeconomy, including the literature on “secular stagnation” (e.g., Summers (2014)). Most of the work in this literature has focused on possible causes for the low interest rate, with explanations ranging from demographics, inequality, and low productivity growth. Our work suggests that there is a potentially important feedback effect from low r back to the real economy through market structure and industry competition….”

Table 2 “…The estimates reported in columns (1) and (2) confirm earlier results. A decline in the interest rate is associated with positive returns for the leader portfolio, and this positive return response to a decline in the interest rate is larger in magnitude when the interest rate is lower.Column (3) uses the 10-year real interest. rate level as before. The coefficient on the interaction between the real rate and the change in interest rate is even stronger than in Table 1. Column (4) shows that the results are driven by both positive and negative changes in interest rates. In particular, the excess return results are materially unchanged whether only positive changes in interest rates or only negative changes in interest rate are used. Column (5) shows that the results are not driven by industry leaders that may have higher duration of cash flows for mechanical or spurious reasons. If industry leaders had higher duration for spurious reasons, then they would have a higher price to earnings (PE) ratio and the difference in the PE ratio between the industry leader and follower at the time of interest rate shock would explain our asymmetric valuation response to a decline in r. Column (5) controls for a “PE portfolio” that is long the top 5% of firms by PE in an industry and short the rest. Inclusion of the PE portfolio return does not change the coefficients of interest, and the return of the leader-minus-follower portfolio is itself negatively correlated with the return of the PE portfolio.4 This result shows that lower r impacts relative rm valuations. not only through changing the discount rate but also through the endogenous changes in future cash flows that favor the current leader…”

“…. Figure 2 helps visualize the snowballing effect, and the critical interest rate at which the snowballing effect becomes active. More specifically, the figure reports non-parametric estimates of the effect of a change in interest rates on the leader portfolio ( ) at various grid points for it1, which is the lagged 10-year nominal Treasury rate. Moving from right to left in the figure, the coefficient estimate of becomes statistically significantly negative when the level of the nominal interest rate it1 falls into the 5 and 6% region. The 10 year nominal U.S. Treasury rate has been below 5% since 2000, with only a few exceptions….”