The incentive for companies to reward shareholders at the expense of bondholders is on the rise as the benefits of maintaining high ratings disappears, signaling that two years of improved creditworthiness may be peaking.
Non-financial companies rated A by Standard & Poor’s have a cost of capital 0.1 percentage point more than those rated one tier lower at BBB, according to Morgan Stanley analysts, diminishing the value of the higher credit grade and erasing their 0.3 percentage point advantage 18 months ago.
Corporations that hoarded more than $1.8 trillion of cash and liquid assets and face slowing economic growth are increasingly turning to mergers, dividend payouts and share buybacks to appease stock investors. Improved credit quality has helped bonds issued by companies to gain 11.5 percent this year, according to Bank of America Merrill Lynch indexes, compared with 7.15 percent for the Standard & Poor’s 500 including reinvested dividends.
“The cash is essentially burning a hole in their pocket, sitting on their balance sheet earning zero,” said Michael Collins, senior investment officer at Newark, New Jersey-based Prudential Investment Management Inc., which has about $254 billion of fixed-income assets under management. “There’s an argument to be made that credit quality is in the process of peaking out.”
Companies from Dell Inc. to Raytheon Co. have issued debt at least in part to repurchase shares. Equity buybacks of $273.5 billion this year have more than quadrupled from the first three quarters of 2009, according to Birinyi Associates Inc. Companies are also taking on more debt with buyout firms led by Blackstone Group LP announcing takeovers at the fastest rate since 2007.
Borrowers that slashed debt and costs following the worst financial crisis since the Great Depression will come under increased pressure from shareholders to boost returns, reversing the improvement in their balance sheets, said Mark Gray, a managing director at Moody’s Investors Service in New York.
Elsewhere in credit markets, the extra yield investors demand to hold corporate bonds worldwide rather than government debentures fell for a second week even as bond sales increased. In emerging markets, spreads shrank the most in almost three months, while prices on leveraged loans climbed for a seventh week.
Spreads on company bonds from the U.S. to Europe and Asia ended the week at 168 basis points, or 1.68 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. That’s a decline of 1 basis point since Oct. 8 and 5 basis points this month. Average yields rose to 3.43 percent from 3.37 percent a week earlier.
U.S. investment-grade bond spreads have dropped 31 basis points since peaking on June 11 to 182 basis points, according to Bank of America Merrill Lynch index data. Yields on the debt fell as low as 3.55 percent last week, the lowest borrowing cost on record in data going back to October 1986.
Credit-default swaps on the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or speculate on creditworthiness, rose 2.3 basis points last week to 98.9, according to prices from Markit Group Ltd. The index, which declined in each of the two previous weeks, has fallen from 106.7 at the end of September. In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings climbed 0.7 for the week to 102.5.
The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
In emerging markets, relative yields shrank 25 basis points for the week, the biggest decline since the period ended July 23, to 244 basis points, JPMorgan Chase & Co. index data show. That’s the lowest since April 26.
National Bank of Abu Dhabi PJSC, the United Arab Emirates’ second-largest lender, said Oct. 17 its board will consider selling bonds under its Australian and New Zealand dollar medium-term note program. The board will meet on Oct. 26, the lender said in a statement to the Abu Dhabi bourse.
The S&P/LSTA US Leveraged Loan 100 Index climbed 0.32 cent for the week to 91.09 cents on the dollar. Prices reached 91.14 cents on Oct. 14, the highest since May 13. The index, which tracks the 100 largest dollar-denominated first-lien leveraged loans, returned 7.14 percent this year.
JPMorgan, the second-largest U.S. bank, led $71 billion of corporate bond sales worldwide last week, a 19 percent increase from the period ended Oct. 8, according to data compiled by Bloomberg. The New York-based bank’s $4 billion offering included the first 30-year bonds from a U.S. bank in 15 months, Bloomberg data show. The $1.25 billion of 5.5 percent debt issued Oct. 14 yields 165 basis points more than similar- maturity Treasuries.
U.S. corporate bond sales this month total $48.5 billion, following $161 billion in September, the most on record for that month, Bloomberg data show.
Raytheon, rated Baa1 by Moody’s and A- by S&P, sold bonds last week with a spread tighter than top-ranked debt typically pays. The world’s biggest missile maker, based in Waltham, Massachusetts, issued $400 million of 5-year, 1.625 percent notes to yield 60 basis points more than Treasuries. The average AAA bond pays a spread of 66 basis points as of Oct. 15, according to Bank of America Merrill Lynch data.
Proceeds from the Raytheon offering, part of a $2 billion debt sale, will refinance bonds and may be used for share buybacks and acquisitions, according to a regulatory filing.
Cost of Capital
Dell sold $1.5 billion of bonds last month. Proceeds were slated to be used to buy back stock, or for investments, additional working capital, acquisitions or capital expenditures, the Round Rock, Texas-based maker of personal computers said in a filing with the Securities and Exchange Commission.
The weighted cost of capital, which incorporates debt and equity metrics, for companies rated A is 7.1 percent on average, compared with 7 percent for BBB companies, Morgan Stanley data show.
The average cost of capital for companies rated B, the second-highest non-investment grade tier, was 2 percentage points more than for companies with BBB ratings, the lowest investment-grade tier. The difference was 4.6 percentage points in May 2009, Morgan Stanley data show. In December 2006, when credit markets were nearing their pre-crisis peak, BBB companies were paying 1.7 percentage points less than B rated companies.
“It does feel like there’s increasingly less incentive for companies to do massive improvements to credit quality, particularly within the investment-grade space,” said Rizwan Hussain, a credit strategist at Morgan Stanley in New York. “Because the pace of credit repair broadly across the market is going to slow down, and potentially reverse in some specific names, the pace of spread tightening should basically mimic that.”
Investors are pouring cash into bond funds this year as the Federal Reserve holds interest rates near zero to avoid deflation and help curb unemployment. Investors committed $181 billion to U.S. bond mutual funds this year through September, according to data from research firm EPFR Global, in Cambridge, Massachusetts.
Fed Chairman Ben S. Bernanke said last week additional monetary stimulus may be warranted because inflation is too low and unemployment is too high.
In another sign that creditworthiness may be at a peak, nonfinancial companies’ total liquid assets fell to $1.845 trillion in the second quarter from $1.847 trillion, the first decline since 2008, according to Federal Reserve data.
The number of companies on review for possible downgrade by Moody’s rose to 42 in August, the highest since July 2009.
As issuance has risen, companies are increasingly engaging in takeovers and dividends. There have been $1.59 trillion worth of deals announced in 2010, on pace to top last year’s $1.78 trillion, according to Bloomberg data. The third quarter was the busiest in two years, with $562.6 billion of announced transactions, led by BHP Billiton Ltd.’s unsolicited $43 billion offer for Potash Corp. of Saskatchewan Inc., the largest deal announced this year.
In the third quarter, 13.6 percent of companies in the Russell 3000 Index increased their dividends, compared with 9 percent during the same period in 2009, Bloomberg data show.
“The M&A thing is a really big deal, and I think that is going to continue or even increase,” said Collins of Prudential. “You’d still rather see that than to have them buy back stock or pay dividends. Those are the worst thing for bondholders because the cash leaves the enterprise value and goes right to the shareholders. We’re definitely seeing an increase in that.”
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