One of the big problems with the artificial equity rally of the past 7 years is that virtually all of its has come on the heels of a historic splurge in stock buybacks: after all even Goldman recently admitted that buybacks have been the sole source of stock buying in recent years.
This in itself would not be so troubling if it weren't for the source of funds used to finance these relentless stock repurchases. Amazingly, if one nets out all other sources and uses of S&P500 corporate cash, virtually every dollar in buybacks has been funded by a dollar of new debt, as Socgen showed several months ago.
To frequent readers, none of this should come as a surprise: we warned about not only the arrival of the buyback bonanza as long ago as 2012, but that the endgame would one that ends in tears for everyone involved.
Now, many years later, the mainstream media is catching up.
In a piece overnight, the WSJ writes that "low rates alone aren't enough to make it easy to pay off a loan. Many companies may find that out the hard way, especially as high-yield debt markets show signs of strain lately."
U.S. companies went on a borrowing binge in recent years. Nonfinancial corporations owed $8 trillion in debt in last year's third quarter, according to the Federal Reserve, up from $6.6 trillion three years earlier. As a share of gross value added - a proxy for companies' combined output - corporate debt is approaching levels hit in the financial crisis's aftermath.
Actually corporate debt has long since surpassed levels hit in the financial crisis's aftermath as we first showed months ago:
What the WSJ does get right, however, is the big picture:
Because those stock buybacks helped reduce companies' total shares outstanding, earnings per share got a boost. Indeed, absent the past three years' share-count reductions, S&P 500 earnings per share would have been 2% lower in the fourth quarter than what companies are reporting, according to S&P Dow Jones Indices.
What it also gets right is something else we warned about back in April 2012, namely that in the age of ZIRP, when hurdle rates are non-existent, the best capital allocation option for CFOs is shareholder friendly activity such as M&A, dividends and of course, buybacks, especially if their own equity-linked compensation rises as a result:
The major reason companies plowed money into buybacks rather than capital spending was that, in a low-growth environment, the returns from investing in expansion didn't seem as attractive as in the past. This is a big part of why companies were able to borrow cheaply: In a low-growth, low-inflation environment, investors were willing to accept lower returns on corporate bonds than if the economy was moving at a more rapid clip.
The rest is history: "most of the debt increase came from bond issuance, as nonfinancial companies took advantage of the lowest rates on corporate bonds since the mid-1960s. That is a plus as companies in many cases extended the maturity of their debt and lowered borrowing costs."
The negative: Rather than investing the funds they raised back into their businesses, companies in many cases bought back stock instead. That was something that many investors welcomed, but it may have come with future costs that they didn't fully appreciate."
Again, a mistake, because it was not "in many cases": it was in all cases. See the first chart again if confused.
But what is more important is that the WSJ correctly hints at what the real issue now that the buyback binge is over and the time to pay the piper has arrived, especially in a rising rate environment:
The sticking point is that in a low-growth environment, paying down debt also may be harder. Especially because companies weren't putting the money they borrowed into capital investments, which provide cash flows to help service debt. The stock they bought back won't do that for them. Even if this doesn't present an immediate problem for all companies given how they refinanced debt to longer maturities, it could be a long-term drag on earnings.
Actually, it is a problem... or rather two.
In a report earlier today, Bloomberg looked at the biggest hangover from this epic debt issuance spree, and found the first big problem, or rather first 9.5 trillion problems: that is how much debt the corporate buyback binge will cost companies over the next 5 years as the debt matures. And clearly, since corporations do not have access to this much funds, they will have to roll it over and refinance it.
As Bloomberg writes, this wave of debt coming due through 2020 is bigger than previous five-year schedules of debt maturities in 2013, 2014 and 2015, according to Standard & Poor’s data. It includes about $2.3 trillion of junk-rated debt, with about $418 billion of that rated B- or lower. And it peaks in 2020, with $2.1 trillion of debt coming due, which is greater than the peaks of the most recent previous maturity walls.
U.S. companies account for $4.1 trillion of the debt coming due through 2020, while European issuers are responsible for $3.7 trillion, S&P data show. More than half of all the debt coming due belongs to nonfinancial corporations.
The real issue, however is the near-term maturities, of which there are $1.8 trillion in 2016 alone, of which $570 billion are US-based Investment Grade maturities.
Bloomberg also hints at the second big problem, one which we discussed extensively at the end of 2015 following the first debt fund gates and liquidations, and especially one week ago when we documented the collapse of the CLO bid: the disappearance of virtually all demand from the primary bond market, most certainly in the junk space, and gradually, in investment grade as well.
If investors don’t return to their carefree ways of lending, global companies will be in for a rude shock. All that money that came so cheaply in the recent past will actually have to be paid back at some point. It’s not just a merry-go-round of lending. The buck must eventually stop with them.
Alas, as Citi's Stephen Antzcak showed in a report released late yesterday, investors are not coming back "to their carefree ways of lending." Quite the opposite.
Here are the big picture bullet points:
- Overview — So far this year the volume of primary market activity has deviated from consensus expectations. But there were bigger surprises, in our view, including the extent to which IG primary market activity has been sensitive to volatility.
- Skittishness in the IG Primary Market – The IG primary market saw roughly 75 no-go days over the past 12 months. This looks worse than even the ’08-’09 episode. There’s a lot of paper that “must” print in the period ahead…where will it price if we’re in a stretch of “no go” days?
- VIP Only Access in HY – HY activity has slowed to a drip, and it seems only the best-in-class HY names are able to garner interest. Will more issuers gain access as volatility ebbs?
- Similar Story in Leveraged Loans – Leveraged loan supply has sputtered overall, and most of the supply has been “event-driven.” As in HY, will we see issuers regain access to loan financing?
Odd: it is "skittishness" when there are no bid in the primary market; did Citi call it "stupidity" or "serenity" when Petrobras 100 year bonds were 5x oversubscribed last June, leading to unprecedented losses just a few months later? In any case, here are the details:
First, investors seem to be more skittish than usual with regard to the primary market, and the primary market responds quickly and dramatically when volatility rises. As noted above, this was evident in the IG market earlier this month when we saw 6 consecutive days with absolutely no new supply. There is a large pipeline of IG deals that “need” to come in the period ahead, and more stretches of no-go days could force issuers to capitulate and price their deals wider than anticipated. This would obviously re-price secondaries.
Second, this investor skittishness has spread from the trouble spots (i.e., energy and basics) to the broader market, particularly in HY and loans. This may not be a problem yet as companies have termed out liabilities (Figure 3, Figure 4), but the extent of access certainly bears monitoring.
Yes, many companies do have termed out liabilities, except for those who have $1.75 trillion maturing in the next 10 months.
Meanwhile, there is a clear buyer's strike which despite the S&P500 being less than 10% off its all time highs, continues with only sporadic intermissions:
it is not just junk bonds where the buyers are stepping away: it is increasingly investment grade, where if one excludes the AB InBev mega deal things are rapidly slowing down. Here is Citi:
On the surface at least, it appears that the IG new issue market has been chugging along at a relatively healthy clip, albeit with higher new issue concessions. By Feb 25th, we’ve already seen $200bn of new deals come to market – that’s 14% ahead of the pace set over the same period in ’15, which was a record breaking year in its own right. With that said, one could make the case that it’s the InBev M&A-driven megadeal that drove the growth in supply (issuance ex-ABIBB is 12% lower YoY).
To our minds though, it’s the increased irregularity of the new issue flows that’s concerning, particularly since we may have something on the order of $570bn of maturities to get refinanced by year-end. Throw in the M&A pipeline, and it’s a large number to push through a stop-and-go primary market.
But for the real horror, look nowhere else than the junk bond space:
Across credit, it’s the HY supply that took the biggest turn over the last 12 months. So far this year HY supply is down ~75% compared to this point last year. Only a meager $12bn via 21 deals were completed, which are basically Lehman-era levels (Figure 7). Aside from the headline volumes though, there are a few other concerning features of the recent supply:
- Extraordinarily concentrated use of proceeds: HY issuance this year is almost entirely attributable to M&A, an activity that is very visible and generally has a set timeline. Very little supply is attributable to any other use of proceeds (Figure 8). Again, this may not be a major problem in the near-term, but obviously will be as time passes and if conditions don’t change.
- High-quality wanted: What’s more, HY supply so far this year is comprised predominantly of just two major deals (32% of YTD supply). Importantly, they are both higher quality HY names from the less troubled sectors (healthcare and technology, respectively).
- Contagion through supply? It’s no surprise that primary issuance exhibits a correlation to secondary market volatility, as both share broader HY risk appetite as a driving factor. Indeed, Figure 9 shows that issuance fell by mid ’15 when there was demonstrably more trading volatility. What’s worth noting, though, is that issuance hasn’t just pared back in the corners of the market where risks were most apparent (i.e., commodities), but rather broadly across even the “safer” sectors.
Here is the best visual of the total carnage in the primary junk bond market:
Keep in mind that hundreds of billions in junk bonds are coming due over the few years in the US alone: absent this freeze in the primary issuance market thawing fast, bond yields will continue rising in a feedback loop, forcing management teams to issue debt with draconian terms, as they scramble to find any buyers.
To be sure, there is demand, but one has to pay handsomely for it, case in point Solera, which as we reported last week, is the subject of one of last year's largest leveraged buyouts, has been struggling to raise money even with Goldman as underwriter.
There was some good news moments ago, however, when the bond issue for the Solera LBO finally priced. The bad news: it did so at a whopping 11.5% yield...
- PRICED: SOLERA $1.73B 8NC3 AT 95 TO YIELD 11.47%
... effectively repricing the entire junk bond market between 50% and 100% higher.
Which is, ironically enough, not the worst news - as Citi notes, only a select few "VIP" companies will be able to refinance regardless of the yield; for most other companies, the refi market sill simply stay shut and the upcoming maturities will lead straight to bankruptcy, without passing go.
The only possible bailout? A full and unconditional Fed relent, with Yellen going back to square one, not just lowering rates, but also unleashing more QE. Because as we have said since day one, ever since the last crisis, absolutely nothing has been fixed and instead constant Fed intervention merely allowed the can to be kicked.
And now the market is about have a rude awakening confirming just this, at which point it will have only one option: crash the market, and force Yellen out of her shell, unleashing another massive Fed easing program.
At that moment the ball will be in Yellen's corner and her choice will be simple: will she go down in Fed history as simply the Chairman who was wrong, and was "forced" to abort the Fed's first rate hike cycle in nearly a decade, or will she go down not only in history, but also in flames, and take the so-called market, Keynesian economics and monetary theory, as well as the entire U.S. economy, down with her?