Negative rates pose corporate conundrum
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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.
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.
“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.
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.