Back in my days of researching companies for a private equity firm, I would sometimes come across companies that used an unusual method of operation called vendor financing.
Vendor financing is a simple concept. A company gives its customers the financing needed to buy its goods or services. If you want to buy my widget, but do not have the money, I will provide you a loan and sell it to you. Of course, you will have to pay back the loan with interest.
If that strikes you as odd, it should. Companies can use vendor financing to increase their sales numbers in the short term. Need a way to boost sales numbers before the quarter is up? Offer customers the opportunity to buy now and pay later. And if you sell to customers with the inability to repay, you can write off the loan later.
Vendor financing is not always bad, but it can be a clue that a company is not above cooking the books just a bit to reach short-term goals.
That is why it has become clear to me that we are living in a vendor-financing economy.
Listening to Federal Reserve Chairman Ben Bernanke testify before Congress last week regarding the Fed’s bond-buying activities reminded me of vendor financing. That is because the central bank has been buying bonds.
In 2011 alone, the central bank bought over 60 percent of all newly issued debt. This has had the Fed’s intended effect of lowering bond yields.
At the beginning of 2011, you could have bought 10-year bonds and gotten yields of 3.5 to 3.7 percent. Today, the 10-year bond yields a paltry 1.4 percent, insufficient to deal with any surprise inflation.
Keeping bond yields low allows the federal government to pay less interest on its $16 trillion debt, which continues to rise substantially each year thanks to annual trillion dollar deficits.
Only a few years back, the big fear was that China’s massive trade surplus with the United States would make the country the largest holder of our bonds. There was the same fear about Japan doing the same thing in the 1980s and 1990s. Today, the Fed has far surpassed these countries.
So what is the danger? For starters, the Fed may soon end up being the only major buyer of our bonds. Other countries can get higher rates by investing their reserves closer to home or in countries offering substantially higher yields.
For individual investors, it means that growth in the United States is overstated. If we had a free market for bonds, yields would be higher. This means that the prices of other loans, such as mortgages and car loans, would be higher as well.
Bottom line: Investors should stay away from the ultra-low rates on government bonds. Those who need a fixed income should look to municipal or corporate debt, where yields are higher. A better strategy is to use market selloffs to buy shares of companies with a history of continually increasing dividends over time.
The best part is, such companies do not need to use shady practices like vendor financing.
© 2013 Moneynews. All rights reserved.