February 26, 2014 3:32 pm

Bondholders pay price of share buybacks

A surge in sales of corporate bonds to fund share buybacks is adding pressure to companies’ balance sheets and increasing risks for holders of corporate debt.

Some of the country’s largest companies, including FedEx, Union Pacific and Cisco, have issued debt this year to help finance stock repurchases.

Companies have raised at least $11bn worth of debt in 2014 for this purpose, according to data from Standard & Poor’s LCD, compared with $19bn raised by companies with similar investment grade ratings for the whole of 2013.

The 2014 figure might be even higher, analysts say, since most companies are not required to say how they use proceeds from debt sales.

Debt has become a cheap source of capital for many companies and a means to reward shareholders, particularly at times when revenue growth is lacklustre.

But for bondholders, such shareholder-friendly practices come at a price.

As companies add leverage to boost their stock prices, the higher debt load, combined with slower growth expectations may lead to credit downgrades and a potential decline in the price of their bonds.

“The money a company uses to fund buybacks is money that simply goes out of the door and it never gets back,” said Jesse Fogarty, a portfolio manager at Cutwater Asset Management.

“It doesn’t immediately raise the probability of default, but as a bondholder I would prefer to see a company sell bonds and use the same amount of money on activities that have the potential to generate cash one day, even with no guarantee of success.”

The practice has increased in popularity among corporate borrowers in the past couple of years as the Federal Reserve’s aggressive monetary stimulus policies brought borrowing costs down to record lows.

Most of the issuance has come from large companies with investment grade ratings and very low borrowing costs. Still, sales by junk-rated companies has picked up and totalled $12bn in 2013.

Analysts at Fitch Ratings said: “While most stock buybacks and dividends are done in a credit-neutral manner, shareholder-friendly actions continue to drive a steady flow of downgrades and negative outlook changes.”

Fitch took six negative rating actions on US companies in 2013 due at least in part to share repurchases.

“The heavy use of bond issuance to fund share buybacks is related to corporations’ reluctance to invest in plant and equipment, which is an increasingly controversial subject,” said Marty Fridson, chief executive of FridsonVision, a financial research company.

“Worse than having bondholders subsidise shareholders is the fact that this strategy does not always work to lift the stock price.”

In this year’s largest deal, Cisco sold $8bn in bonds, in which a portion of the proceeds was earmarked to return cash to shareholders through share buybacks.

The sale follows the company’s warning that its fiscal third-quarter results may miss some analysts’ estimates. Cisco has already bought back $4bn of its own stock in the three months through to January 25, but its shares are still lagging behind gains in the S&P 500 Information Technology group.

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