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The Fly In The Buyback Ointment: Corporate Leverage Is At Record Levels
We’ve gone out of our way over the last year to explain that whatever monthly flow was lost to the taper was promptly recouped by corporate management teams via an endless stream of ZIRP-induced buybacks.
Put simply, thanks to the now ubiquitous global hunt for yield, anything that even looks like a creditworthy company can borrow for nothing and then promptly funnel the proceeds into EPS-inflating buybacks. That’s great from a myopic, “let’s worry about this quarter first and longevity later” perspective, but in the long-run, it can’t possibly work as all you’re doing is leveraging the balance sheet to explain away a poor top line.
Indeed, this has become a hot-button issue on the campaign trail as Hillary Clinton, at the likely behest of Cheryl Mills, is out to attack the "tryanny of the next earnings report."
Still, “investors” are stupid (sorry, the filter is off tonight) and algos just scan headlines, so as long as the bottom line looks good, the equity continues to rise. But with Eccles QE gone (for now anyway) and with the cost of capital expected to rise in December (hold your breath), the question is this: what happens to quarterly earnings once the buyback bonanza beat is history?
Citi is now out questioning just how long PMs are going to entertain the proliferation of financial engineering now that i) we're in a revenue recession, and ii) coporate leverage is sitting at record highs.
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From Citi
Corporate leverage continues to push higher. In Figure 3 we present the debt-to- EBITDA ratio for the average non-fin in the IG and HY markets. We see that in IG leverage rose from 1.8x to 2.1x over the past twelve months, and in HY it rose from 4x to 4.4x (Figure 3). Note that in both markets, at current levels gross leverage for our sample set is well north of the ‘09 highs. Unfortunately, we see little chance that it will decline in the near-term, or even stabilize for that matter, as the earnings backdrop appears to be too soft.
Until recently, rising corporate leverage was primarily the result of companies desire to bolster shareholder value at the expense of bondholders — issue bonds and buy stock or issue bonds and buy a company. But in recent quarters declining earnings have been an important reason for the upward trend (Figure 4).

The 3-fold increase in share buybacks in the past five years has been the key driver of corporate re-leveraging (Figure 5). In large part, buybacks have been the result of strong incentives provided to corporate managers by activists in particular and equity investors in general.
But there are signs that this may be changing. Recent conversations that we’ve had with equity PMs suggest that they have become far more focused on revenue growth, and are placing far less of a premium on any financially engineered EPS growth.
Why might equity investors be less impressed with financially engineered growth now than they were a short while ago? One of the key reasons may simply be because default risk has risen, and historically when default risk rises buybacks tend to fall.
This relationship exists in part because equity holders have a claim on future cash flows. While buybacks increase that cash flow stream itself (per share), they also lower the probability of equity holders actually receiving that cash flow stream. After all, should a company default equity holders may very well end up with no claim at all.
Figure 5 highlights the relationship between buybacks and the default rate over time at the macro level, and in Figure 6 we show the debt outstanding and share price relationship for a specific issuer (DAL). Note that we can find any number of examples where more debt equates to a lower share price rather than a higher one.

Given that we are clearly moving into a higher default environment we believe that equity investors may be inclined not to reward stocks that have large buyback programs. And if this is the case, corporate managers will have a diminished incentive to borrow money to finance buybacks.
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Got it. So what Citi is saying is that now that corporate leverage is at record levels, the game is officially up and once the defaults start and the cost of capital begins to rise, no sane equity investors (of course nowadays the idea of a "sane" or even a "human" equity investor is an oxymoron) will ever buy into the story nor even think about throwing money at a secondary.
Needless to say, that's bad news for corporates that have to this point relied on ZIRP to stay afloat and it's also bad news for anyone betting on fresh highs on the S&P. This will only get worse as pressure from Presidential candidates overwhelms the whims of the 2 and 20 crowd when it comes to dictating how corporate management teams finagle the bottom line and so, if Citi is correct, expect PM's to be less impressed with EPS "beats" going forward which means either Janet Yellen will need to step back in to provide the bulge bracket with the monthly dry powder they need to fire up the prop desks, or else it may be time to take profits.
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Unwind time.
No Way!! Cut me another line! The sun will never rise! The party will never end!
Even though it is dysfunctional and a little nasty. Part of me is enjoying this clown show of the always raising DOW despite horrible shipping, GDP etc.
It will be fun watching CNBC when things do unwind. (If CNBC is still on the air when it happens.)
So it nearly the right time for Goldman to 'pull it' and acquire everything for pennies on the dollar.
We wiped some ointment on some folks!
Um that's not ointment, it's anal lube.
Once all the foriegn bond holders bail on the euro bonds, they have no other place to stick that money except US stocks. So sooner or later as strange as it may be, the US buy back kids won't have to buy back!
Nice hallucination. Now watch reality unfold.
Money always flows to the what one veiws as the safest place. You will see.
Yeah, that might be a place which has audited it's gold reserves.
There is a time I would have mistaken this for satire.
To state the bleeding obvious, if the trend continues the S&P will have new highs on or before Wednesday.
ZH predicting it won't get there?
Followed the whole 'corporate bonds at $0' would also indicate that. But how do we know it will be NOW rather than in a few weeks?
It's print forever or nukes fly. There s long time left in forever.
This is merely one aspect of the overall problem.
https://thinkpatriot.wordpress.com/2015/10/24/lebowski-enlightenment-9/
The system is FUBARed because we allowed lousy control system concepts to corrupt the political system. This system is too complex and too corrupt, it will fail, not reform. Next time, engineers need to be consulted about the control systems, this didn't work.
https://thinkpatriot.wordpress.com/2015/05/29/straight-from-the-horses-ass/
No boom boom with buybaks. Too beaucoup.
A far as I am concerned, stock buybacks are nothing but a form of embezzlement...
Here is why; http://incapp.org/blog/?p=2681
Nah, nothing inherently wrong with buybacks as a mechanism. There is an optimal amount of capital a company can deploy regardless of where it is in its lifecycle. It should and must return excess capital to investors somehow, be it with divideds or buybacks. Buybacks are way better for tax reasons.
And debt is cheaper than and thus preferrable to equity up to some optimal point beyond which default risk becomes a problem. The current buyback stampede is only a trainwreck in the making because companies are using buybacks to manipulate impressions rather than for legitimate return of capital and are taking on excessive default risk in the process.
Glad the 'filter' wasn't on today!
Fink wants to be treasury secretary, hence putting Hillary stooge Mills on his board. Mills don't know squat about financial anything.
The tyranny of telling the owners of the company the performance of their assets.
As if reporting results is the problem.
Maybe board members who approve executive compensation are...
So what Citi is saying is that now that corporate leverage is at record levels, the game is officially up and once the defaults start and the cost of capital begins to rise, no sane equity investors (of course nowadays the idea of a "sane" or even a "human" equity investor is an oxymoron) will ever buy into the story nor even think about throwing money at a secondary...
imo you are correct about what citi is saying but what citi is saying is flat out wrong. This is pure poppycock:
Why might equity investors be less impressed with financially engineered growth now than they were a short while ago?
Equity investors don't give a rat's ass about the long term. The algos aren't even worried about the next quarterly report, they only care about the next microsecond's directional flow. the default rate didn't go up organically in 2008 and 2009, ben bernanke jacked up the ffr rate so companies couldn't roll over their mammoth debt load. janet yellen isn't going to let that happen. the tipping point may be hit somewhere down the road but you can bet your ass it won't happen with the maggots we have now at the helm.
It rubs the lotion on its skin or else it gets the hose again.
IMHO the buyback unwind will be slower than most think.
When interest rates go up the market value of the debt already on the balance sheet drops -
Companies can buy the debt back for less than the face value and book a profit - increasing EPS.
If a company - even a poorly run one is still generating free cash flow - they will be able to manipulate EPS for a few years.
If there is a rate hike, it likely won't go beyond 1% and won't last.
Without soaring interest rates, it's questionable that debt buyback proceeds would be large enough to counterbalance EPS declines from deleveraging. Even if they could temporarily, stockholders would see the steep cliff drop in earnings coming beyond the next quarter and value shares lower accordingly.
Meanwhile, the slightest slowdown in the economy occurring at any time will apply crushing force to heavily levered companies lugging around ginormous debt service obligations. That lever works both ways.