|Low Interest Rates||High Interest Rates|
|High Equity Premium||Low Equity Premium|
|Net Profit Margin||High||Low|
|Share Price & Enterprise Value||Low||High|
This is complicated in a business cycle shock because frequently firms experience operational dislocations and/or are pushed out of their optimal capital allocation targets. But, at this late point in a cycle recovery, when dislocations have been generally repaired, when interest rates go up, leverage will go up, profit margins will decline, and share prices will increase from both revenue growth and multiple expansion.
This might seem counterintuitive in some ways, but this should follow from a Modigliani-Miller framework where corporate income is taxed. Where I think intuition is wrong is that we tend to conceive of debt in a consumption context. Debt tends to be described as a risky and greedy attempt at overconsumption, or for corporations, a dangerous way to create false growth that exposes them to higher risk.
Of course, a firm leveraged imprudently would face high risk. And, firms that have been exposed to deep revenue shocks tend to meet their ends when they can't pay the interest payments on their debt any more. But, I think what we see mixes with these perceptual biases in a way that creates a false interpretation. If a firm didn't have any debt, it might fail at the point when it couldn't pay its workers anymore. Would we say that hiring workers is a risky proposition that, generally, causes firms to fail? I suppose in any failure we can claim that workers were overpaid or unproductive. But, generally, clearly, firms need workers to produce. So, while hiring workers inefficiently would be a problem, workers themselves are not a source of risk. I propose that debt is the same. It can be handled poorly, but it is simply a part of the stakeholder structure of the firm, and is not, in and of itself, a risk. Some workers might have fixed salaries while others receive wages tied to profits or revenues in some way. And, some capital (debt) receives a fixed payment while some capital (equity) received residual payment. All firms must decide on a mixture of fixed and variable costs, but there will always be a reasonable level of fixed costs above zero.....Anyway, I'm going on too long.
Over time, total required real returns on firm capital appear to be fairly stable. Generally, when interest rates fall, equity risk premiums rise. This suggests that there are fairly stable factors regarding delayed consumption and the myriad other factors that create profit for investment and that within the ownership claims on investment, there is a risk trade between debt and equity. Debt holders trade risk with equity holders. So, instead of having a single class of owners in a unlevered firm, there are owners with a certain payout structure and owners with the remaining residual payout structure. Because certainty has value, debt holders accept a discounted payout, and thus, the equity premium is always positive.
The long term balance between debt and equity does seem to follow the trends I described in the table above, and this can be explained with the Modigliani Miller framework as a product of corporate taxation. But, note, this also aligns with a risk-trading perspective. Low interest rates are a sign that investors have become risk averse, and they are willing to trade away a higher discount from the unlevered return on assets to the remaining equity holders in order to minimize local risk. We might imagine that the demand for low risk ownership would push debt levels up. But, this would leave a bifurcated set of investors - many investors with low-return/low risk payouts, and few investors with very risky payouts. It may be more realistic to imagine a normal distribution of investors where the mean level of risk aversion has increased, and the entire body of investors has shifted or skewed. So, when investors as a group become more risk averse, driving down interest rates, the marginal investor in the switch between equity and debt will also be more risk averse. Corporate deleveraging changes the nature of equity, making it less volatile, and thus low interest rates are associated with falling debt levels as the marginal investor is attracted into the less volatile equity position.
If there is any truth to my framing above, the comparison of the earnings yield on equities and the yield on bonds is not very helpful. There may be a tendency for earnings yields to decline when interest rates are low. But, this may be related to the deleveraging of equities, so that the lower earnings yield simply reflects the lower relative risk of equities in that context.
A low earnings yield may not be a signal to a risk-insensitive investor to switch to bonds. It may be a signal to leverage up or beta up her equity portfolio.
Regarding the graph, the earnings yield looks like it tracks with leverage as much as it tracks with interest rates. (Note, as an aside, the unusual behavior during two demand shock recessions in the 2000's, where revenue shocks caused earnings to decline and leverage to increase, both temporarily, as corporations were thrown into disequilibrium.)
One could say that leverage and earnings yield track simply because they both have equity value as the denominator. That is true. It is interesting that debt as a proportion of net operating profits is fairly stable over time, and that is what leads to this co-movement.
On the other hand, the co-movement of the earnings yield and bond yield is problematic for another reason. The bond yield includes an inflation premium. The earnings yield is simply a measure of the trailing earnings. The inflation premium will come from future nominal growth of earnings and share price. When this adjustment is made, these indicators don't move together as tightly in the high inflation 1970s. In fact, using an equity risk premium (which takes growth expectations into account) instead of an equity yield, there tends to be an inverse relationship so that inflation adjusted interest rates and equity premiums tend to add up to a fairly stable return level.
I suspect there are times when a low relative earnings yield should signal higher weights in bonds and other times when a low relative earnings yield signals higher weights in equities (to make up for low leverage). I don't know if there is a coherent way to decipher the signal. As such, I'm not sure how useful earnings yield relative to bond yield is as an allocation tool.