4/23/2015

Bond investors grumble at buyback bonanza - FT.com

April21,20158:34am

Bond investors grumble at buyback bonanza

RobinWigglesworth

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Bloomberg

Shareholder activists are on the prowl, and fearful executives are taking no chances. US
companies are expected to hand a record $1tn to shareholders this year through dividends
and stock buybacks. But not all investors are thrilled at their munificence.
While shareholders have applauded the tidal wave of corporate cash washing back into their
portfolios which has helped power US stocks to successive records in recent years some
bondholders are eyeing the generosity with concern.
Much of the dividends and buybacks have been funded by
healthy corporate cash flows, after companies assiduously trimmed costs and pruned
investments following the financial crisis. But some are borrowing money from bond
markets to mollify their shareholders, often under pressure from aggressive activist
investors or even just the threat of one appearing on the horizon.
As a result, some investors and analysts argue that the outlook for bonds issued by solid,
investment grade-rated companies has dimmed somewhat, after a fine run that has pushed
average yields back down to just 2.8 per cent, close to the pre-taper tantrum record low of
2.6 per cent and compared with the long-run average of almost 7.9 per cent.
The investment grade space doesnt look attractive right now, because of tight spreads, the
rise of activism and creeping leverage, says Jim Keenan, head of credit at BlackRock.
Bondholders dont have the same voice as shareholders, except what we charge.
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Bond investors grumble at buyback bonanza - FT.com

Investors and analysts stress that US blue-chip companies remain robust, with most gauges
of corporate creditworthiness better than in the pre-crisis heyday, when an efficient balance
sheet in other words, a healthy dollop of leverage to burnish returns was the mantra of
savvy executives.
Nonetheless, corporate balance sheets are not as pristine as they were in the years after the
financial crisis. In a recent report Moodys estimated that US investment grade companies
were towards the end of last year sitting on cash equal to 35 per cent of their adjusted annual
earnings, down from an average of 43 per cent in 2013 and 51 per cent in 2009.
While the ratio of debt-to-earnings remains about 2.2 times, the ratio of cash-to-debt
slipped to 15 per cent in the third quarter of 2014, the lowest since 2007. The rating agency
highlighted that once adjusted for shareholder payouts, free cash flows as a proportion of
debt servicing is even lower than it was before the financial crisis.
Credit quality is beginning to erode, notes
Robert McAdie, head of research at BNP
Paribas. There will be downgrades, not
defaults. But we are seeing the virtuous cycle
end.
Some money managers sense an opportunity in
the mismatch between the worsening
underlying fundamentals and the stilldepressed prices investors charge to lend.
Cohanzick Investment Management, a $1.6bn
New York-based asset manager, last year
launched a fund dedicated to betting against
investment grade corporate debt.
The story in investment grade is buyer beware, says David Sherman, the head of
Cohanzick. We live in an age where no company is protected from shareholder activism...
Its a real problem for investment grade bonds. The spreads are reasonable, its just that the
credit quality is eroding.
Cohanzicks fund is shorting the bonds of
companies including Pepsi, AT&T, Walgreens,
Oracle, McDonalds, CBS and Emerson. Pepsi
isnt going to go bankrupt; I just think people
havent yet realised that its leverage is going
up, Mr Sherman says.
Still, betting against investment grade corporate
bonds has been a reliable way of losing money
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Bond investors grumble at buyback bonanza - FT.com

in recent years. Bondholder concern over

buybacks is nothing new, yet yields have
continued to grind lower as demand for fixed
income markedly outstrips supply. The spread
over Treasuries is tight, at about 130 basis
points, but it was well below 100 bps before the
financial crisis, when corporate balance sheets
were in worse shape.
Ryan Preclaw, an analyst at Barclays, argues
that the health of highly rated US companies
has not deteriorated significantly, given that
falling interest rates mean debt burdens are
easier to shoulder.
He also points out that in many cases activist investors are primarily clamouring for
operational or governance shake-ups that help both shareholders and bondholders, rather
than demanding debt-finance buybacks. Its fashionable to look at, but theres not a lot of
evidence that its a problem, he argues.
In fact, the steady supply of debt sales used to finance dividends and buybacks has largely
been welcomed by bond markets desperate for fresh supply as inflows into fixed income
have continued to gush.
BlackRocks Mr Keenan highlights blockbuster bond sales by Apple that were explicitly used
to fund payouts to shareholders. The companys creditworthiness remains unimpeachable,
and investors have made money as the bond prices have appreciated, he points out. In
many cases these deals provide our clients opportunities to lend to some really good
companies at a good level.
Kevin Giddis, head of fixed income at wealth manager Raymond James, is also relatively
relaxed about blue-chip US companies taking advantage of low borrowing costs to return
more money to shareholders as long as moderation remains.
They probably have some room to add leverage, he says. The danger is that they feed at
the trough too long.
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