Article13 Mar 2013

Shareholder vs. Bondholder: The Pendulum Swings Back

Citi GPS Opinion Article
In the immediate aftermath of the Lehman crisis corporate managers were unambiguously focused on bondholders — solidifying ratings, paying down debt, hoarding cash, etc. — but to say that this mentality has shifted since then is a dramatic understatement. Companies are now re-levering, and the scale of this activity has certainly picked up recently. But more important is that we see little reason for this trend to change in the period ahead, and we also believe that the pace of activism may be more dramatic than many expect. This may not be a problem for credit spreads in the near term, but in the longer term the overall market may be more vulnerable to any negative catalysts.

Shareholders gaining ground, leverage moving higher

Companies have clearly been looking to benefit stockholders in recent years — in fact, our equity traders note that the number of activist actions (e.g., proxy fights) increased 25% last year vs. 2011. And the amount of share buybacks and dividends paid out is on pace to reach about $190 billion when the Q4 ’12 numbers are finalized, which would be an increase of about 23% vs. 2011 and a jump of more than 150% versus the lows reached back in 2009 ($72 bn).

That said, shareholder-friendly activities are not necessarily a negative influence on credit valuations  unless they come at the expense of bondholders. And to a large extent this is exactly what seems to be happening. To illustrate, we looked at the leverage trends among approximately 275 non -financial high-grade issuers. The average company in our sample experienced 23% growth in total debt amount since early 2010, while earnings grew 17% over the same period. This means that leverage ticked up, which is certainly not a positive for bondholders.

But more worrisome to us is that the average does not really reflect what the typical corporate manager is doing, because the average tends to be driven by a few extremely large companies. If we look at changes in total debt and earnings for the median issuer we find that total debt grew by 32% since early 2010 while earnings increased by only half as much, or 16%. As a result, leverage in a median context is rising more sharply.

Key reasons for shareholder-friendly focus

There is a fairly wide range of companies that are pursuing shareholder-friendly activities, one cohort being companies that may have decided that absolutely pristine balance sheets are no longer needed (e.g. Google). Another group includes issuers that had reduced debt post-Lehman, but now appear to be returning to pre-Lehman levels (e.g., Celgene and FLIR Systems ).

In general, we see three key fundamental reasons behind the re-leveraging trend:

* Low incremental borrowing costs : Current borrowing costs are obviously hovering near all-time lows. For example, the yield for the typical single-A company is 2.4 %, relative to a historical norm of 5.1% . But just as important, in our view, is that the incremental difference between higher- and lower-rated credits is very modest as well. For example, in yield terms the typical single-B currently trades at 5.8%, or only 3.4% more than the typical single-A; historically this difference has been 4.5%. What this means in practical terms is that it really doesn’t cost an issuer all that much to NOT protect their balance sheet.

* Why should Treasurers care about the balance sheet? Consider this question in the context of a very simple equity valuation model:

Stock price = Earnings * P/E ratio * Probability of not defaulting

Essentially, this model argues that an equity investor’s claim on an income stream partly depends on the company’s ability to avoid defaulting. We understand that equity holders would want to put the least amount of capital as possible into a company to boost ROE, but at the same time in a bankruptcy scenario an equity investor’s claim on income may very well end up being zero. As such, the goal for a stockholder may be to put not so much capital into a deal yet still have a minimal chance of default.

The important point here is that by many metrics the probability of default for the typical company is near all-time lows. Why not lever up?

* Reasonable valuations: In addition, P / E multiple s are also fairly low. Based on the same pool of high-grade issuers introduced above, we find that the consensus one-year forward P / E ratio for the typical issuer is now 14.8, relative to a historical norm of 17.6.

Expectations for re-leveraging may be too low

So we see a number of reasons why the re-leveraging trend is likely to continue, but we also believe that the pace of activism may be a bit more dramatic than many expect. The reason is at least partially attributable to the Fed. It seems that it took quite some time before investors realized that it is very difficult to fight the Fed — risk on! But our take is that corporate Treasurers may be feeling the same pressure (risk on!), and our sense is that some investors may not appreciate the extent of this pressure yet.

In a world awash in liquidity one needs to keep an open mind about how much re-leveraging can occur. Think about LBO screens — deal size of less than $15 b illion and an equity stake of 30% have, until very recently, been used as the criteria by the consensus. This assumption was in large part based on the view that sponsors would be unwilling to commit more than $1 billion to $2 billion to any deal, and club deals (a private equity buyout that involves several private equity firms) are very hard to do in the current environment. But then the Heinz deal was announced, with a deal size of $25 billion and 50%+ “equity.” If private equity shops are writing small checks deal size may be a limitation, but in a yield-starved world with an extraordinary amount of liquidity it could also simply leave room for other investors to participate (e.g., pensions, sovereign wealth funds, etc.).

When we run the numbers for companies that screen well for an LBO based on the typical criteria, we find about 85 issuers with around $200 billion of debt outstanding. If we adjust the filter to be more consistent with recent deal announcements, we more than double the LBO candidate list (to 174 names) and debt outstanding ($514 billion in total debt). Think big (or at least bigger), in our view.

Key point: We expect that the re-leveraging trend will continue in the period ahead, perhaps more so than the consensus expects. The trend probably won’t weigh on broad market spreads in the near term, but may leave the market vulnerable to any negative catalyst that might emerge in the longer term.


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