Buyers of America's corporate debt have had an easy ride over the past few years.
After taking on too much debt in the late 1990s, companies have spent the early years of this century getting rid of it. As a result, corporate credit quality has improved, bond prices have risen and debt holders no longer have to lie awake at night worrying if their investments are going to implode suddenly in an unexpected debt default.
Still, this seemingly benign climate belies hidden dangers: the risk that companies, having pacified bondholders, start switching their attention to shareholders.
Increasingly, this is what American companies are doing. Last month Viacom's chief executive, Sumner Redstone, jolted analysts when he told a conference the company was considering accepting a lower debt rating and increasing its leverage. Mr Sumner is worried about the relatively low price of Viacom's stock, which has traded below $40 for much of the past year after hitting more than $70 in August 2000, and he wants the company to raise money so that it can boost its share price, either by increasing its equity buybacks or making acquisitions.
Analysts have taken Mr Sumner's comments seriously. Moody's Investors Service and Fitch Ratings immediately put Viacom's A3 investment-grade debt rating on review for downgrade, while analysts at bond research firm Gimme Credit recommended investors swap out of Viacom debt into more “attractive” credits like Comcast, Cox or Time Warner. “Viacom has made it clear that it is not likely to be bondholder-friendly in the near future,” says Dave Novosel, a Gimme Credit analyst. Bond fund managers are becoming concerned that other companies are thinking along the same lines, particularly since the S&P 500 Index is down 2 per cent in the year to date.
Equity buybacks are running at their highest levels since the late 1990s. Last year $269bn of buybacks were undertaken compared with $322bn in 1997, according to Dealogic. So far this year there have been $37bn worth of buybacks a fairly heady pace if annualised over the year.
Some worry that the buybacks can be inappropriate, arguing that some companies do not have enough cash on their balance sheets to justify undertaking them and are doing it to “goose” their stock prices.
Vincent Boberski, managing director of fixed income research at RBC Dain Rauscher, says banks and brokerages including Citigroup and American Express as well as utility companies are among the worst offenders for buybacks that are unwarranted.
Others say it is hard to gauge in the short term whether a stock buyback is a good decision, and what matters is the expected rate of return. James Paulsen, chief strategist at Wells Capital Management, says there has been a cultural shift and it is more acceptable today for companies to return money to shareholders in the form of higher dividends and equity buybacks.
In the late 1990s, when the investment culture focused on future growth opportunities, companies would be penalised for raising dividends, Mr Paulsen says. “It was an admission that there was no potential for growth.” Today, he adds, investment is often seen as a risky use of capital.
But while equity investors may reap the rewards from buybacks, it is clear they are taking a toll on bondholders. There were 44 credit ratings downgrades related to shareholder payments last year, a record that was last equalled in 2000, according to Moody's. There have been six such downgrades in 2005.
Meanwhile, the resurgence in M&A activity is hurting some debt investors. Investment-grade companies involved in M&A deals are more likely to have their ratings downgraded than upgraded, according to John Lonski, chief economist at Moody's. The retailer Sears is expected to lose its investment grade status when it completes its merger with Kmart in March. For the time being, companies can afford to accept a lower credit rating because financial markets are liquid and credit spreads are tight, making selling debt relatively cheap.
They do, however, take the risk of running into difficulty if liquidity deteriorates and it becomes harder to raise money and make debt payments. Bondholders may then find they are once again in the unpleasant position of worrying about debt defaults.
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