Thanks to voracious demand from yield-starved fixed income investors and rock-bottom borrowing costs courtesy of the Fed, high grade corporate issuance hit a record $348 billion in Q1 of this year and junk bond supply came in close to $93 billion during the same period. Some companies — such as heavily-indebted shale producers — have used the proceeds from bond sales to stay in business, a dynamic that’s helped to create a global, deflationary supply glut [8]. Better positioned companies in the US have taken the opportunity to fund massive buybacks [9] with debt issuance and as regular readers are acutely aware, share repurchases by price insensitive corporate management teams are in large part responsible for underwriting the rally in US equities.
Of course, leveraging balance sheets to artificially inflate the bottom line and boost equity-linked compensation comes at a cost — even if the ill effects don’t show up for years to come. When companies spend the proceeds from debt sales on buybacks while ignoring capex, they jeopardize future growth and productivity in order to engineer phony EPS beats even as revenue growth stagnates, or even declines. Below are updated graphics which illustrate the extent to which capex as fallen completely out fashion relative to buybacks.
[10]
From Credit Suisse:
In the US, capex to sales and net business investment as a share of GDP are a little higher than in Europe, but still not especially high by historic standards. In our view, levels of capex are relatively subdued because buybacks as a style are still outperforming, and this is incentivising corporates to pay back cash, not to invest. The economic recovery in developed markets has, if anything, been 'capex light'.
Here are the updated versions of some graphics from Citi which we've shown before. These demonstrate the extent of corporate re-leveraging and clearly show that debt sale proceeds are being channeled into buybacks and dividends at the expense of business investment.
From Citi:
We looked at leverage for a sample of about 150 IG industrial benchmarks, and found that it doesn’t look good.
[11]
Of course, if leverage is going up today because it’s funding tomorrow’s growth that might not be a bad thing. Unfortunately, that’s not what’s going on.
[12]
* * *
The question is what happens when rates begin to rise and inflows into corporate credit turn to outflows. In other words, what happens when tapping heretofore insatiable demand for corporate issuance in order to perpetuate the equity rally and engineer EPS beats is no longer an attractive option? As we've seen, organic growth is hard to come by in a post-crisis world characterized by lackluster demand, and when the easy money dries up (making massive buybacks and blockbuster M&A more expensive), corporate America may wish it had invested a little less in chasing an equity rally and a little more in growth, efficiency, and productivity.