Is Corporate Behavior Too Bubblicious in Bond Market?
Armed with record cheap debt, corporate Treasurers are becoming increasingly aggressive with how they use financing, a trend some analysts see as possible red flags for their bonds and stocks.
Companies raised $1.2 trillion this year largely to restructure existing debt, but also to fund activities that favor their shareholders — such as buybacks and dividends. Some of this activity is being spurred by the uncertainty around the pending "fiscal cliff" and also the idea that tax rates for dividends will rise from the current 15 percent rate no matter what Congress ends up doing. (Read More: Fiscal Cliff, Complete Coverage)
In the fourth quarter alone, companies have announced nearly $35 billion in special dividends, some of that funded by debt.
Yet, many corporate debt strategists say the signs of a bubble are just not there, based on the healthiness of the borrowers' balance sheets and the fact that there is huge appetite for the paper in a low yield environment. Strategists, however, do say the quality of debt issuance has peaked, as more companies are using debt for mergers and financial gymnastics in a low growth environment.
"With each deal they seem to be kicking up leverage," said Bill Eastwood, trader and managing director at Newfleet Asset Management. "At the end of the day, are we happy to see that as creditors? Absolutely not, but as long as it's not agregious and aggressive and as long as we are comfortable with the business then we are okay with it."
While companies have raised debt to fund dividends and buybacks in the past, there is a much larger than normal rush to sprinkle shareholders with large special dividends before the likely tax law change at year end. The likeliest candidates have been those with large insider ownership, lots of cash, or private equity investors looking for a payout.
With the bond market wide open for business, some strategists expect to see more companies using the debt market to appease shareholder activists. For instance, Ingersoll Rand this week said it would spin off its security business and raise debt to fund a $2 billion share buyback. The company was under pressure from Nelson Peltz. After the announcement, Moody's said it would review the company's ratings for downgrade.
"Not only are yields low, but the covenants are pretty lenient," said Jack Ablin, CIO of BMO Private Bank, of the recent batch of corporate deals. "It certainly was a bubble we saw several years ago. I think we're probably creating a credit bubble again, but that's by design." Ablin said the Fed is trying to encourage activity with its near zero interest rates policy. (Read More: Fed Action Risks Inflation, Veers Into Fiscal Policy: Lacker)
Even Goldman Sachs CEO Lloyd Blankfein laid out a case for caution, when asked by CNBC if the corporate bond market was forming a bubble. "One of the big risks that's looming is the complacency ... by which people are once again complacent about this low level of interest rates," Blankfein said. (Read More: Investors Face Big Risk Over Interest Rates: Blankfein)
But still, corporations are advised to take advantage of low rates. "We're advising all companies, and they don't need much prodding, to borrow as much as they think they're going to need as long as they think they're going to need it, because interest rates are so cheap," he said. But he noted that investors seeking duration are investing in those bonds. "At some point there will be a reversal. That will have an effect on portfolios, and people will have losses."
RBS strategists identified more than two dozen S&P 500 companies that announced debt offerings to fund dividends or share buybacks this year. Macy's, Disney, Costco, Amgen, and Western Union are among them.
"There's probably a lot longer shadow list of companies that raised debt under general corporate purposes and have either accelerated dividend payments or paid special dividends. Oracle is on this list," said Ed Marrinan, RBS head of credit strategy
In the case of Western Union, that company's debt was downgraded by Moody's late last month to Baa1 with a negative outlook. The ratings agency specifically cited "continued shareholder friendly actions" alongside concerns about the profitability of its money transfer business.
"It's when the edgier companies do this sort of thing that the rating actions follow pretty quickly," Marrinan said. "Clearly it's becoming an increasingly popular strategy as companies gain greater confidence that economic activity is poised for more improvement as we head into 2013."
Joel Levington, managing director corporate credit at Brookfield Asset Management, said Western Union is an investment grade company to watch, and the bonds it issued this week are already trading below par. Western Union earlier this week completed an offering of $750 million in 3- and 5-year senior unsecured notes. He said often investment grade companies would issue bench mark 10-year or 30-year securities.
"If you look at their stock performance, they've been a huge underperformer for quite some time," he said. "Over the past five years, Western Union has underperformed the S&P 500 by 52.9 percent. So when you see something like that, it always goes (to me) to the left hand side of the balance sheet to asset quality and the management of those assets…The equity market is clearly making a statement."
Hewlett-Packard is at the top of the list of investment grade companies with an unattractive profile, strategists say. Moody's cut HP's long-term credit rating to A3 from Baa1, three levels above junk. The company took a massive $8.8 billion write down against its 2011 $11.1 billion acquisition of Autonomy, accusing it of irregular accounting methods. Moody's said HP revenues will fall five percent next year, pressuring profit margins, and it cut its forecast for free cash flow for next year to $4 billion from $6 to 7 billion — based on corporate restructuring and weaker operating performance. (Read More: How a Desperate HP Suspended Disbelief for Autonomy Deal)
"It's really an interesting case," said Levington. "Instead of being able to focus on external growth to move into new markets … they're really focused on cleaning their balance sheet up."
Levington also points to Safeway as an unattractive investment grade bond. Safeway stock also underperformed the S&P by 52 percent over the past five years. "They've been downgraded a year ago in November to the lowest rung in investment grade. It's a name that could easily tip over," he said. He said the company's $2.1 billion in share repurchases outpaced the company's cash flow. "What I'm seeing is their borrowing went up $1.3 billion," he said
"It's just an exchange of money from debt holders to equity holders. They're ratcheting up their financial risk. In the case of Safeway, they're doing it where they're paying out more to shareholders than they are generating in cash," he said.
Most of the investment grade companies that have tapped the debt market to fund dividends have the financial fortitude to do so, even if their ratings are temporarily hit. Costco was rapped by Fitch for issuing debt to pay for its $7 per share or $3 billion dividend. It cut the retailer's issuer default rating to A plus from AA minus. Fitch said the debt offering will increase Costco's leverage ratio to 1.7 times on a pro forma basis, and it would remain elevated over the next three years but that it should return to a lower level longer term as it does not expect Costco to issue further debt.
Eastwood said debt tied to dividends is not necessarily a bad thing, and he bases his decision on the health of the overall business, whether the company is viable and how much leverage they are adding.
For instance, Michaels Foods, plans to use some of its $275 million offering to fund a dividend. But Eastwood said the company is taking its debt ratio back to its prior LBO level.
Strategists say companies that have made their debt less attractive tend to be small and medium-sized companies. Eastwood points to two recent offerings he found unattractive. One was Stallion, and the other SumTotal. "Those were two we passed on," he said. However, HCA Holdings is using its $1 billion in senior notes due 2021 to pay for its $2 a share dividend to shareholders on Dec. 21. "It goes back to quality of the business," Eastwood said.
RBS found the following companies among those that specifically said they were paying for dividends and share buybacks with debt: