Are companies starting to turn the dial away from bondholders and towards shareholders?
It is a question investors and analysts are increasingly asking as the cheapness of debt and relative costliness of equity gives companies big opportunities. Some groups such as Microsoft and Hewlett-Packard are already exploiting what UBS is calling the most attractive relative cost of debt-to-equity in 30 years by issuing bonds in order to buy back shares.
“We think we are at a tipping point in terms of corporate behaviour. Companies have been deleveraging and have got ample cash on their balance sheets: we believe we are at the start of the process where the focus will shift back to shareholders,” says Sunil Kapadia, global asset allocation strategist at UBS.
With equities still an unfashionable asset class for most investors and companies hoarding record amounts of cash, investors are urging companies to take the matter into their own hands and take action to prop up their own valuations. “I can’t see investors changing their minds any time soon so in a way it has been left up to companies to step in and act as asset allocators,” says Robert Buckland, equity strategist at Citi.
One side of the coin is the well-known cheapness of issuing bonds. Microsoft set a new record last month when it issued three-year debt with a coupon of just 0.875 per cent. On the flip side is the relatively high cost of equity. Comparing the free cash flow yield of stocks and shares against the yield for US Treasuries, Citi analysts found that the difference between the two has become positive in the past few years in both the US and Europe.
That gives companies an enticing arbitrage opportunity between the cost of debt and equity. The question is: how many of them will take it on? Mr Buckland says: “If you can borrow money in the corporate bond market at 3 or 4 per cent and buy cash flow in equity markets at 7 per cent, then you have got a 3 or 4 per cent carry. Some companies are going to take this on.”
Evidence is already building that many companies are prepared to do this as share buy-back activity starts to rebound after plummeting last year.
Data from Birinyi Associates, a research group, shows that in the second quarter of this year executed buy-backs – those that actually happened compared with those that were merely announced – rose to $85bn in the US. That is back where buy-backs were in the middle of 2005, although this is still a long way off the peak of $228bn reached in the third quarter of 2007.
Mark Bamford, head of global fixed-income syndicate at Barclays Capital, says: “We are seeing a number of companies exploring the idea of accessing the debt capital markets to retire more expensive equity capital.” Few are willing to make the connection explicitly but companies such as McDonald’s and HP have issued debt and made buy-back announcements close to each other recently.
UBS calls this phenomenon “releveraging”. Mr Kapadia says: “Companies and investors should use the currency of cheap credit to unlock equity valuations. There is a huge incentive for companies to leverage again given this valuation gap.”
Analysts at Citi see it as part of a broader trend, to which they give the particularly ugly name of “de-equitisation”. In essence, this looks at the total number of shares in issue and whether this number is rising or not. Rights issues or flotations cause shares in issue to rise whereas buy-backs and acquisitions cause this number to fall. Citi even argues that increased dividends should be seen as part of its “de-equitisation” trend as it is the preferred form of returning capital for many investors.
BHP Billiton’s $39bn hostile bid for Potash is a good example of potential de-equitisation. If this deal were to proceed, BHP would issue no equity but would finance itself entirely through bank loans and bonds. Heath Jansen at Citi estimates that these current funding costs are less than 2 per cent and would rise only to 3-4 per cent as a bridge loan is replaced by long-term corporate bonds.
Citi recommends looking at strong companies that face persistent takeover speculation such as Anadarko, or Capital One in the US, or ITV and Prudential in the UK; or groups that have consistent policies on buy-backs such as Akzo Nobel, BASF, Lockheed Martin or Texas Instruments; or businesses with a high dividend yield and a history of increasing it such as Deutsche Börse, Vivendi, Altria and Qwest.
But while many see a clear trend towards deleveraging as – post the crisis – companies finally start to favour shareholders over bondholders, some bankers are sceptical. “It is very cynical to view providing balanced returns to shareholders as bad for bondholders,” says Larry Wieseneck, head of global finance at Barclays Capital. “Hoarding cash is not so good either: shareholders get very nervous, and bondholders should get even more nervous.”
Perhaps the most intriguing part about de-equitisation is the suggestion from some that it could have helped J apanese companies as deflation took hold in the 1990s, with some arguing that it could have helped prop up share prices. With a persistent fear of deflation still in western countries, it gives companies more food for thought. “If there is one country in the world where the de-equitisation trade has made sense for 13-14 years it is Japan,” Mr Buckland says. “De-equitisation would have done a world of good to Japanese stock markets.”
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