Bond Binge Pushing Leverage Toward Financial Crisis PeakCharles Mead
Company debt loads in the U.S. are approaching the highest level since the aftermath of the financial crisis as borrowing to finance mergers and shareholder payouts exceeds earnings growth.
Debt levels have increased faster than cash flow for six straight quarters, boosting the obligations of investment-grade companies in the second quarter to 2.09 times earnings before interest, taxes, depreciation and amortization, according to JPMorgan Chase & Co. That’s up from 2.07 times in the first three months of 2013 and compares with 2.13 in the third quarter of 2009, when it peaked after the deepest recession since the Great Depression.
Businesses from Apple Inc. to Comcast Corp. have tapped credit markets this year to take advantage of the lowest borrowing costs on record before the Federal Reserve decides to pull back on measures intended to boost an economy that’s forecast to expand this year at the slowest pace since 2009. The leverage trend can’t be sustained, JPMorgan analysts led by Eric Beinstein wrote last week in a report, and a combination of rising rates and high cash balances may curtail issuance.
“They are stretching their metrics and leaving themselves exposed to the risk that there isn’t a full-scale recovery,” Rajeev Sharma, who manages $1.5 billion of fixed-income assets in New York at First Investors Management Co., said in a telephone interview. “Once rates start to spike up, you should see less new issuance and some kind of normalization” in leverage, he said.
Investment-grade companies have issued $739 billion of bonds in the U.S. this year, according to data compiled by Bloomberg. That’s a faster pace than in the same period of 2012, when a record $1.12 trillion of securities were issued by borrowers ranked Baa3 or higher by Moody’s Investors Service or at least BBB- by Standard & Poor’s.
While earnings growth has remained limited, “there has been no moderation in the pace of debt,” the JPMorgan analysts wrote in an Aug. 23 analysis of 190 non-financial companies. Borrowings increased by 9.1 percent in the quarter ended June 30 from a year earlier, rising to a decade-high of $2.9 trillion even as Ebitda dropped 2.3 percent, led by declines in the metals and mining industry.
“A lot of debt issued in the last year has been to finance mergers and acquisitions and rewarding shareholders,” said the analysts, whose New York-based firm underwrites the most corporate bonds worldwide. Those trends “seem to be declining” and “we expect that companies will reduce the rate of debt issuance due to rising yields and high cash balances,” they wrote.
Elsewhere in credit markets, Sanofi, France’s largest drugmaker, sold its first bonds in euros since November 2012. The cost to protect against corporate-bond losses in the U.S. reached the highest level in more than seven weeks.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, fell 0.3 basis point to 83.8 basis points as of 11:50 a.m. in New York, according to prices compiled by Bloomberg. The measure, which jumped 5.3 basis points the previous two days, earlier rose to as high as 85.1, the highest intraday level since July 8.
In London, the Markit iTraxx Europe Index, tied to the debt of 125 companies with investment-grade ratings, fell 0.8 to 106.7.
The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit 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.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 2.1 basis points to 15.75 basis points, the lowest since July 29. The gauge typically narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of Fairfield, Connecticut-based General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5.9 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Paris-based Sanofi offered 1 billion euros ($1.3 billion) of 1.875 percent, seven-year securities to yield 27 basis points more than swaps, Bloomberg data show.
While an economic recovery in the U.S. following a 2.8 percent contraction in 2009 helped companies improve their finances and lower leverage to a ratio of 1.83, credit metrics have since deteriorated, according to JPMorgan data that excludes automakers.
Gross domestic product in the world’s largest economy will expand 1.6 percent this year after a 2.8 percent increase last year, according to the median estimate of 73 economists surveyed by Bloomberg.
Comcast has issued about $7 billion of bonds this year, $4 billion of which helped finance a $16.7 billion payment to General Electric for its remaining stake in broadcaster NBCUniversal. The largest U.S. cable provider’s debt-to-earnings ratio has since climbed to 2.25 at the end of June from a more than decade-low of 1.94 a year earlier.
“We view our balance sheet as a strategic asset and are focused on strengthening our financial position over the next few years with a medium-term leverage ratio target of 1.5 to 2 times,” Michael Angelakis, Comcast’s chief financial officer, said on a July 31 conference call with analysts to discuss second-quarter earnings.
Apple, which is paying shareholders $100 billion to compensate for a stock that’s been hammered by signs of slowing growth, sold $17 billion of bonds in April, the biggest corporate offering on record. That added leverage to a balance sheet that had been debt-free since 2003.
It also lifted the total amount of cash delivered to shareholders in the second quarter by investment-grade companies to $485 billion, a 1.5 percent increase from the previous period, JPMorgan data show. That’s 57 percent higher than the average over the past decade, though the level has declined from a year earlier, the analysts wrote.
“As companies are less and less able to deliver earnings growth through internal efficiencies and top-line growth, and at the same time shareholders are pushing for increased rewards, they’re turning to financial engineering to push returns,” said Alan Shepard, an analyst and money manager at Madison Investment Advisors Inc., which oversees about $16 billion in Madison, Wisconsin. “Borrow the money at low rates to finance repurchases and you can drive earnings-per-share growth.”
Steve Dowling, a spokesman at Cupertino, California-based Apple, didn’t respond to telephone and e-mail messages seeking comment on the company’s finances.
“People have been forced into accepting that lower credit quality is the new norm,” said Robert Smith, the chief investment officer at Austin, Texas-based Sage Advisory Services Ltd., which oversees about $10.5 billion.
While heavier debt burdens have been supported by a Fed policy that pushed average U.S. corporate-bond yields to a record-low 2.65 percent in May, JPMorgan strategists said they expect issuance to slow as interest rates increase. Speculation is mounting that Chairman Ben S. Bernanke will reduce the central bank’s $85 billion in monthly debt purchases as soon as next month.
With a greater sense of urgency to tap debt markets before rates climb higher, companies may continue to increase leverage through the end of the year, Bank of America Corp. debt strategist Yuriy Shchuchinov said in an Aug. 26 note.
The Fed speculation helped lift borrowing costs to 3.5 percent through Aug. 26, according to the Bank of America Merrill Lynch U.S. Corporate Index. That’s still more than 2 percentage points less than the 5.9 percent average over the last 20 years.
“As the yield curve continues to move higher, companies may be more reluctant to increase leverage to reward shareholders,” Shepard said. “Eventually the debt has to be refinanced or retired, and the odds are that it won’t be done at the historical low rates of earlier this year.”