The recent bull market in bonds is creating a compelling financial arbitrage opportunity for corporations with the wherewithal to take advantage. Investment grade companies that can issue debt at a low rate have multiple higher-return uses for those funds: To buy-back their own stock; to invest in a new business opportunity; or to make a strategic acquisition. Companies with large cash balances arguably have even more to gain from a similar arbitrage. The implications, quite obviously, are bullish for stocks – especially those of investment grade quality.
Corporate managers are beginning to take notice and respond. IBM recently issued three-year money at 1%. Meanwhile IBM’s earnings yield is nearly 10%. IBM can use that money merely to buy back its stock (as it has done each year) and earn a 9% spread. IBM’s historical ROE is closer to 20%. Assuming IBM can invest in a new business opportunity that achieves this hurdle, the company would earn a spread of 19% - compelling! IBM is not alone. Wal-Mart and AT&T both recently raised 5-year money at less than 2.5%, well below their earnings yield - again, a compelling arbitrage. Johnson & Johnsonjust raised 10-year money at the lowest rate on record for a corporation (2.95%). If JNJ were to use that money to buy back its stock, the transaction would be immediately cash flow positive given JNJ’s nearly 4% dividend. Any capital appreciation over the next 10 years would be pure gravy.
Companies are beginning to deploy their excess cash as well. Why earn virtually zero on that cash when strategic acquisitions are available at a 15% long-term return? Intel’s acquisitionof McAfee and BHP’s hostile bid for Potash were both all cash bids made at large premiums. Both companies deemed strategic acquisitions a much better use of cash than demand deposits.
Look for these types of transactions to increase going forward. The math is too compelling for corporate leadership. If the fixed income market holds at current levels, I would expect private equity to begin to take more aggressive advantage of this arbitrage as well. As this trend gathers steam, it should provide both a floor and a tail wind to stock prices.