One of this year’s key narratives has been the degree to which US stocks have benefited from a perpetual, price insensitive bid. By that we of course mean corporate buybacks, which one might fairly characterize as having replaced the monthly flow lost to the Fed taper.
The buyback bonanza shown above is of course sponsored by ZIRP. Put simply, when borrowing costs are close to zero and when the market has become completely myopic as it relates to assessing performance, it makes sense to issue debt and plow the proceeds into EPS-inflating share repurchases. Throw in the fact that the FED-induced hunt for yield has forced risk averse investors out of govies and into corporate credit and you have a kind of goldilocks scenario for corporate issuance and buybacks.
This all comes at cost. That is, you can’t simply keep leveraging the balance sheet to artificially inflate earnings. Eventually, some of the proceeds from debt sales need to go towards capex or wage growth or something that’s conducive to boosting productivity, long-term growth, and competitiveness. However, that simply won’t happen in a world governed by what Hillary Clinton correctly (yes, she has managed to get at least something right believe it or not) calls the “tyranny of the next earnings report.”
Once you understand all of the above, you can begin to see why a lack of market depth in the secondary market for corporate credit is so dangerous.
You have an environment that encourages record issuance and the proliferation of bond funds along with the now ubiquitous hunt for yield means any and all supply is promptly snapped up. But if those bonds ever have to be sold in a pinch, there’s no one home at dealer desks thanks to Volcker.
All of this would be bad enough as it is, but as WSJ reports, it’s exacerbated by the fact that companies are now funding their own share buybacks by selling bonds to .. wait for it.. other companies. Here’s more:
Companies reaching for better returns on their cash have found a new favorite investment—other companies’ bonds—and they are loading up.
Cash-rich companies like Apple Inc., Oracle Corp. and Johnson & Johnson are snapping up corporate bonds sold by highly rated companies such as Verizon CommunicationsInc. and Gilead Sciences Inc.
More than half of corporate cash held by U.S. companies this August was invested in investment-grade corporate bonds, a record, according to investment-software company Clearwater Analytics. Meanwhile, treasurers have reduced their companies’ holdings of more traditional investments such as U.S. Treasurys, commercial paper and bank certificates of deposit.
Companies are betting highly rated corporate bonds are safe repositories for cash that will pay higher rates than more traditional bank deposits or money-market funds. But they are also increasing the risk to an asset where principal protection is the priority.
If interest rates rise quickly, the value of their lower-yielding existing bonds could plummet. A major market disruption could also make it difficult for companies to sell their holdings if they need the cash. Either could lead to write-downs or actual losses if they sell at lower prices than they paid.
For now, treasurers are figuring the bet isn’t that risky. Companies’ balance sheets are in good shape, and buyers are focusing on bonds that mature within five years, which carry lower risks than bonds that take longer to mature.
“To get more return, you have to take more credit risk,” said a treasurer at a large technology company that has actively been buying corporate bonds.
Well yes, and to be sure, when companies are flush with cash it's important to figure out how best to invest it, but then again, you now have corporate Treasurers talking like sellside credit strategists and needless to say, when you're buying all kinds of corporate bonds at the tail end of a credit supercycle, you're liable to get burned badly (on paper anyway) if and when rates start to rise.
Of course companies should also consider what would happen in the event of an economic meltdown. After all, the very same conditions that would lead to a downturn and force corporate management teams to raise cash will also serve to make the secondary market for corporate credit even more illiquid than it already is. In other words, if you think there's a dearth of buyers now, just wait until someone hits the panic button and when the firesale starts (likely after someone at a Vanguard or a BlackRock tries to transact in size to meet a wave of redemptions), corporate treasurers will find themselves in a decisively unenviable position.
We close with the following from Harvard's Victoria Ivashina:
“This is a risky business. Can they get it wrong? Absolutely they can get it wrong.”