The logo of the German bank Commerzbank...The logo of the German bank Commerzbank is seen on a branch (R) and the headquarters (L) of the bank in Frankfurt/M., western Germay, on April 7, 2011. Germany's second biggest bank, Commerzbank, unveiled plans on April 6, 2011 to raise billions of euros in equity to pay back most of the state aid it received in 2009 during the global financial crisis. Commerzbank said it would redeem 14.3 billion euros ($20.4 billion) of a total 16.2 billion in silent participations held by the government by June 2011, and pay the rest by 2014 at the latest. AFP PHOTO / DANIEL ROLAND (Photo credit should read DANIEL ROLAND/AFP/Getty Images)
© AFP

Life for companies in Europe has been turned upside down. Like individuals, corporate treasurers are accustomed to paying when they wish to borrow and being rewarded for building up cash piles.

No longer. Companies, particularly large ones, are now able to borrow at historically low interest rates. But saving money has never yielded so little.

Some banks have even imposed negative interest rates on deposits — charging corporate clients for holding their cash. On Monday, HSBC became the latest to introduce a charge on cash held in a basket of European currencies.

“Treasurers must now be questioning whether it makes sense to have substantial cash balances when you are not remunerated for it,” says Myriam Durand, Emea managing director for corporate finance at Moody’s, the credit rating agency.

In Europe, in particular, low or negative interest rates bring a further worrying downside. Companies have been sitting on their cash for some years now, when investment is badly needed to drive lacklustre growth. However, even with rates at their current levels, companies’ bosses — and their investors — find themselves in a Catch 22 situation: they hold high levels of cash on their balance sheets, on which they are earning almost no return, but remain puzzled about how to put it to better use.

Among European companies, this conundrum is widespread — unlike in the US, where large cash piles tend to be concentrated in a few companies and sectors. Cash piles at European non-financial companies stood at more than $1tn a year ago — more than 40 per cent higher than in 2008. Analysts believe there has been little decrease since.

“The desire to hold cash despite ever-lower returns reflects the high level of uncertainty that has been palpable since the financial crisis, particularly in Europe,” Goldman Sachs points out.

In some sectors, such as telecommunications and utilities, low to negative real interest rates have proved a boon. With many companies in these industries still highly leveraged, lower rates have made it possible to refinance more cheaply and, often, at longer maturities — reducing overall debt servicing costs.

Negative interest rates

Debt issued by companies in the IBOXX EUR corporate bond index carries an average coupon, or fixed interest payment, of 3 per cent. But the average yield on these bonds when bought in the market is 1.1 per cent, suggesting that companies’ interest costs could be reduced further.

However, while managing debt may have become easier, that is only one side of the story. With HSBC and Germany’s Commerzbank now setting negative rates for deposits, and positive rates at all-time lows, no company is earning a meaningful return on cash balances — a situation that is increasingly causing disquiet among investors.

Paul Watters, head of corporate credit research at Standard & Poor’s, says that while companies in Europe have been inhabiting a low-interest rate world for some years, moves such as Commerzbank’s have “focused minds” — encouraging shareholders to ask managers why they are not putting cash to better use.

Negative interest rates

“Are returns [on cash] really better than investing in your own business?” he asks. “What is the opportunity cost of maintaining cash balances?”

In recent months, there has been evidence of investors pressing companies to explain what they will do with their cash piles. Vivendi, for example — the Paris-based owner of Universal Music Group and Canal Plus — had to increase its dividend payments after pressure from an activist US investor to hand over more of its estimated €15bn in cash.

It may be the first of many companies to be forced to adapt its policies. In the US, share buybacks and dividend payouts picked up sharply in the wake of the financial crisis, as companies sought to support their share price by promising income when they could not guarantee growth.

Although European dividend growth has significantly lagged behind the US, there are signs that this is beginning to change. According to S&P, dividends and share buybacks by rated European companies grew to over €250bn in 2014 — close to their 2007 peak and about €100bn more than during the worst of the financial crisis.

Negative interest rates

Diverting cash into mergers and acquisitions may also help to placate investors, given improving investor sentiment towards dealmaking. Goldman Sachs has found that companies making acquisitions in 2011 and 2012 were generally punished in terms of relative stock performance, but says market reaction has changed in the past two years. Even so, M&A activity involving European targets is still running below the levels of 2005.

And while more cash may be used for share buybacks, dividend hikes, or dealmaking, there is still little sign of it being diverted into investment — a key driver of future growth in Europe. Capital expenditure remains anaemic.

There is a further unanticipated consequence of the low interest rate world, which affects both companies and shareholders.

“The real danger is that negative real interest rates sustain assets and investments that would otherwise fail in an environment of more normal interest rates,” says Goldman Sachs. “At the very least [they] make it difficult to assess the ‘correct’ valuation of assets.”

Such a danger could result in the creation of a generation of “zombie” companies in Europe, preventing oversupply being eradicated from the region’s economy. This, combined with a continuing absence of corporate investment, poses long-term risks.

“Extremely low interest rates or even negative yields could discourage investors even further from risk taking, due to a lack of profitability, and hence lead to less expansion and growth creation,” warns S&P.

Companies for the moment may be enjoying a flood of cheap money in Europe, but there are perils lurking in its depths.

Why lower rates mean higher liabilities

When Daimler used €2.5bn of the cash on its balance sheet to top up its pension fund last December, it rather took the market by surprise. But the move by the German carmaker, while unusual, reflected another unintended consequence of the flood of cheap money from the European Central Bank. Many companies’ pension deficits have widened significantly because the discount rate used to value pension liabilities has fallen in tandem with interest rates.

Lufthansa is also suffering from this unwelcome side-effect of the low interest rate environment. Earlier this month, the airline said the deficit in its defined benefit pension scheme had risen by more than 40 per cent since December, and is now more than €10bn. Lufthansa wants to scrap DB pension arrangements for employees but has yet to negotiate a less onerous scheme with unions. Its pilots have gone on strike repeatedly to protect early retirement benefits.

Similarly, the deficit in Siemens’ pension plan rose to €11bn at the end of March, from €9.6bn at the end of December. At BASF, the chemicals manufacturer, pension provisions more than doubled to €9.6bn in the first quarter, compared with a year earlier. Standard & Poor’s, the credit rating agency, estimates that a 50-basis point change in discount rates adds a whacking €1.85bn to BASF’s liabilities.

It is not just pension fund trustees in Germany that are feeling the pain. Standard & Poor’s estimates that, in 2014, the sharp fall in long-term bond yields increased the post-retirement benefit obligations of the top 50 companies it rates in Europe by 11 to 18 per cent. It is predicting a further widening of scheme deficits this year. Even at the end of 2013, pension schemes at these 50 companies were underfunded by 30 per cent, or nearly €200bn.

Pension deficits are not debt in the conventional sense, and many companies face no statutory requirement to set aside financing for them. Nor have S&P or Moody’s downgraded any company’s credit rating because of a widening of its deficit. S&P believes, however, that if interest rates remain low, pension deficits will become a more material negative factor over the next two years. More companies, in that case, may have to follow Daimler’s lead.

Copyright The Financial Times Limited 2024. All rights reserved.
Reuse this content (opens in new window) CommentsJump to comments section

Follow the topics in this article

Comments