Corporate debt: CEOs’ conundrum

Some bosses will find minuscule borrowing rates dangerously tempting

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The Sun Ain’t Gonna Shine Anymore. The Walker Brothers song was number one in the charts in April 1966, the last time the yield on investment grade corporate debt was as low as today. Then and now, Moody’s calculates that US BAA-rated companies could borrow at 5.36 per cent. The worries about many countries’ sovereign debt and indeed the US credit downgrade makes the corporate option look safer. The conundrum for canny chief executives is how to take advantage of the debt sunshine.

For companies that deleveraged after the financial downturn, the easy answer is to leverage up and use the borrowed money to buy back shares. At the current interest rate, any company whose share price is less than 18.7 times earnings will gain an immediate earnings per share benefit – the S&P 500 currently trades at a forward PE multiple of 12 times. This will be especially tempting for bosses whose remuneration is based on their company’s EPS (or derivatives of it).

But too large buy-backs can lead to accusations of a lack of original ideas. That makes it tempting to increase profits through debt-funded acquisitions. At current interest rates, a company trading at 12 times earnings can pay a 20 per cent takeover premium for a company of the same size selling at the same multiple – and achieve an EPS boost of about 23 per cent. That should result in an approximately proportionate share price rise.

Overexcited investors may wish to pause for thought. They are investing in corporate debt because they believe it to be relatively safe. However, lower borrowing costs encourage risk taking – the antithesis of the buyer’s investment goal. In contrast with countries under a debt cloud, companies’ capital structures can hang on the whim of just one person. Some bosses will find minuscule borrowing rates dangerously tempting.

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