Shareholders set for $1tn bonanza

Corporate raiders 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.

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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 Moody's 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 still-depressed 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 . . . It's a real problem for investment grade bonds. The spreads are reasonable, it's just that the credit quality is eroding."

<>Cohanzick's fund is shorting the bonds of companies including Pepsi, AT&T, Walgreens, Oracle, McDonald's, CBS and Emerson. "Pepsi isn't going to go bankrupt; I just think people haven't 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 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 means 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. "It's fashionable to look at, but there's not a lot of evidence that it's 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.

Mr Keenan highlights blockbuster bond sales by Apple that were explicitly used to fund payouts to shareholders. The company's 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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