Between March 2022 and July 2023, the Federal Reserve aggressively raised benchmark interest rates to put a lid on inflation that had reached its highest levels in more than four decades. Those rate hikes put a damper on markets, and companies have been hesitant to issue debt amid uncertainty about where rates will go from here.
One stock that suffered was Moody's(NYSE: MCO), which saw its primary revenue source take a hit. But the company, one of the longest-held positions in Berkshire Hathaway's portfolio, weathered the challenges well. And, with the Fed signaling that it's done raising rates for this cycle and could cut them in 2024, Moody's could benefit in a big way.
Debt issuance dropped off significantly last year
When inflation first began to pick up in 2021, the Fed was slow to respond. The central bank's leaders pointed to supply chain disruptions as the primary culprit, and they predicted that the inflationary pressures would be temporary. However, by early 2022, it was clear that higher inflation wasn't going to ease on its own, and that the Fed needed to act.
During the past two years, the Federal Reserve raised the benchmark federal funds rate by 525 basis points (5.25%) from the near-zero level it had slashed it to early in the pandemic. That was one of the fastest paces of interest rate hikes in decades, and it had a tightening effect on the economy overall. It also put a damper on business investment, which relies heavily on debt.
Debt issuances by companies plummeted, and Moody's felt the impact. As one of the largest credit ratings businesses in the U.S., it evaluates the creditworthiness of companies, governments, or other entities by assessing their ability to meet their financial obligations.
In 2022, the tightening financial conditions resulted in a 34% decline in fixed-income issuances across all debt types (including government, mortgage-backed securities, and corporate debt). This was a stark contrast from 2020 and 2021, when Moody's credit ratings business boomed as debt issuance surged amid favorable market conditions for borrowers. Corporations and governments took advantage of ultra-low interest rates and issued debt to fund operations, mergers and acquisitions, and other projects.
Chart by author.
The credit ratings business slowed, but analytics kept Moody's afloat
Last year, revenue from Moody's Investors Services (MIS) segment, which includes its credit ratings business, declined by 29%. The company cited muted credit market activity, central bank interest rate hiking, and heightened inflationary and recessionary concerns as reasons for the decline. Overall revenue fell 12% while its diluted earnings per share plummeted 37%.
One bright spot was Moody's Analytics (MA) segment, which includes its data, research and insights, and decision solutions. This segment's sales grew 15% last year as the company benefited from rising demand for credit and economics research, data, and know-your-customers solutions (technology that companies use to verify and authenticate their customers' identities, and prevent money laundering, fraud, and other illicit activities).
Falling interest rates could give Moody's a boost
Inflation has come down significantly -- the November consumer price index report showed year-over-year inflation of just 3.1% , well below its 9.1% peak in June 2022. And the Fed has not raised interest rates since July.
The Fed committee members predict that they'll deliver three rate cuts in 2024. CME Group's FedWatch Tool, which gauges the market's expectation for interest rates, suggests investors believe there could be as many as seven rate cuts by the end of next year. Market participants project that those rate cuts could start as early as March.
Interest rate cuts could spur a resurgence in debt issuance, especially among companies that have been waiting for more certainty about where rates are headed. That would be welcome news for Moody's MIS business. This segment's revenue rose 2% over last year but remains down 26% from 2021; pent-up demand for debt issuance could give the segment a boost over the coming years.
Blair Shwedo, head of U.S. sales and trading at U.S. Bank (a subsidiary of U.S. Bancorp), told Reuters, "This should be an extremely welcome environment for corporate issuance."
According to a November 21 research report from JPMorgan Chase, "A stable yield and rate backdrop will be an important factor in loan issuers' ability to access the primary market in 2024, particularly for refinancing." The report forecasts a 10% increase in gross institutional issuance from this year.
Moody's is a solid stock for long-term investors
Moody's posted a solid third quarter, as revenue and diluted earnings per share grew 15% and 31%. Meanwhile, the stock's recent 26% rally since November has it priced more in line with historical valuations. However, the company could see its MIS business revenue get a boost from more favorable borrowing conditions, which could drive both earnings and the stock price higher.
Moody's is well-positioned in the credit ratings business as the second largest player in the U.S., behind only S&P Global. It has a strong competitive advantage, and has ridden out this difficult time thanks to strong demand for its analytics business.
We can't know for sure what interest rates will do next year. However, if rate cuts release some of the pent-up demand for debt, Moody's stands ready to serve. Not only that, but the company's robust business model has proven it can endure challenging times, making this Buffett stock an excellent one to buy and hold for the long haul.
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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway, JPMorgan Chase, Moody's, S&P Global, and U.S. Bancorp. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.
