Arbing Refi And High Dividend Event Risk

Bernanke's transfer of capital from savers to corporations, courtesy of now perpetual ZIRP and trillions in upcoming QE, has made corporate refinancing for high grade companies a no-brainer. With Goldman issuing 50 year bonds at just over 6%, one can be sure that many companies will take the inflation call option and continue to refi existing IG debt into ever lower yields, courtesy of schizophrenic investors who are betting on both inflation and deflation (why else would someone lock up capital for 50 years even as the S&P trades at 20110 highs?). However, in addition to merely refinancing, banks are now also also eagerly incurring new debt for shareholder friendly activities. So what does that mean for investors who are obviously much more comfortable with putting their capital into bonds than stocks (23 weekly outflows from mutual funds)? Well, there's an arb for that.

As Bank of America observes, by first deconstructing the attractiveness of debt funded dividends for low debt, high grade companies, there is a substantial event risk for a variety of IG companies, which can be traded using CDS, and hedged using offsetting positions in a basket of low-risk names. In other words: buy CDS in event risk names, and sell CDS in low event risk. That said, BofA ignores the fact that a variety of companies on both sides (but especially in the short risk basket), don't have access to offshore cash with repatriation and taxation. Which is why, in addition to the Bank of America recommended trade, we go back to our suggestion from a month ago, which suggested buying CDS in cash rich companies whose cash horde, however, is offshore, such as tech names, and hedging it by selling CDS in domestically cash rich heavy IG names.

First, here is a simple synposis of why courtesy of ZIRP, funding dividends using debt may well be a no-braner.

The Corporate Capital Structure Trade

The current environment where interest rates have reached record lows, partly for technical reasons as explained above, has created risk for debt holders from a unique capital structure trade opportunity where corporations can enhance shareholder value by issuing debt to repurchase own shares. To see this, suppose that initially a corporate capital structure is optimal in the sense that leverage maximizes shareholder value. Then following a significant decline in the cost of debt – without a corresponding decline in the cost of equity – the capital structure is no longer optimal as there has been a decline in the cost of debt relative to equity. Specifically, corporations can enhance shareholder value by increasing leverage – for example by issuing debt to buy back shares.

In addition to a need for restoring an optimal capital structure, the current low cost of debt has two important incentives to increase leverage, as we show below. First, because the after-tax cost of servicing debt is below earnings yields many companies can design recapitalizations to increase earnings per share (EPS). Also, for companies with high dividend yields exceeding the after tax cost of debt the recap is self financing. In other words, the savings from not having to pay dividends on the repurchased shares are more than enough to service the new debt.

We highlight an event risk trade that we continue to recommend among low beta names – short a basket of names with event risk, long a basket without event risk.

Example of a recap

Below we show in Chart 8 and Chart 9 a hypothetical example of a recapitalization. Initially this company has no debt, earns $1/share ($1 EPS) and pays out a dividend of $0.5/share. With current low interest rates this company issues a $250 bond at an annual after-tax interest cost of 3% to buy back shares. Assuming for simplicity an unchanged share price this recapitalization has the effect of lowering after-tax earnings by 8%, but since the number of shares outstanding declines by 17% there is an $0.11 improvement in EPS.

Whether this increase in earnings per share enhances shareholder value depends on the new P/E multiple that the market assigns to the company given the new capital structure. Importantly, because the dividend yield in this example exceeds the after-tax cost of debt, the savings from not having to pay dividends on the shares repurchased are more than enough to cover the cost of servicing the new debt – we see that as +$0.5 in “interest coverage” in Chart 9 above. More generally we show in the sidebar chart (Chart 10) how this extra financial incentive increases with dividend yield. Note that, while we keep the dividend payout per share constant in this example, alternatively the company could choose to use the $8 in dividend savings on the repurchased shares to increase dividend payments per share.

Luckily for those who wish to hedge risk, there is a sufficient distribution around the mean to arb event, aka recap risk:

Chart 11 puts into perspective the magnitude of divergence between simple measures of costs of debt and equity for non-financial high grade (HG) companies. For the median company the earnings yield is 5.5 percentage points above the after-tax cost of debt. The degree to which the cost of equity exceeds the after-tax cost of debt is fairly evenly distributed around the median value. Moreover, as Chart 12 shows, for names with above median differences in relative costs, 45 companies have relatively high dividend yields above 3%.

And as the topic of this post is event hedging, the way to capitalize on the eagerness of everyone to refi, even though only half the companies will be able to pull it off without an impact on their credit standing and P/E.

Event Risk Trade

We continue to recommend a trade buying CDS protection on a basket of single-A or above rated industrials, selling protection on a basket of similar names but with little event risk as highlighted in Table 1 below. As can be seen in Chart 13, names with event risk have been underperforming since mid-summer.

Of course, at the end of the day the far more material question is how long is this ridiculous low interest rate sustainable for. Granted, companies may now be rushing to not only refinance existing debt and incur new debt in shareholder friendly moves, but the second rates turn up, all the IG names that are now trading at sub 50 bps will be the first to get hit. Which is why only pension and mutual funds should be selling naked CDS at sub 50 bps spreads, without a hedge on the other side. In fact, the only trades that should be established are pair trades, despite the fact that equity Long/Short investing is now pretty much dead: luckily, credit still makes a little sense.



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