By Eric Schaefer
Chart of the Week, December 18, 2012
Amidst all of the talk of special dividends and the anticipated tripling of marginal income tax rates on dividends in 2013, non-financial corporations have quietly been re-jigging the liability side of their balance sheets. Equity is out. Debt — in all forms — is in.
The Federal Reserve Board reports non-financial corporate businesses bought back $308.9 Billion in equities through the 3rd Quarter, paid for by $365.3 Billion in new debt. While this pace, on an annualized basis, represents a moderation compared to 2011, it still represents a significant restructuring of corporate balance sheets.
There are three undercurrents impelling corporate treasurers to leverage up the balance sheet.
The first is the historically low level of interest rates. Baa-rated bonds today yield 4.66 percent, compared to 1.74 percent for 10-Year Treasury notes. The ongoing bull market in corporate debt has pushed yields 59 basis points (bp) lower over the past year. In turn the insatiable investor appetite for yield is squeezing already tight yield spreads. Today the Baa-10-Year Treasury spread stands at 292 bps, down 37 bps from one year ago.
Concurrently, the average maturity of new corporate debt issued has increased. In November, $119.4 Billion in new debt was brought to market with an average maturity of 16.5 years. A decade ago — in 2002 — the average maturity was just 8.3 years. In essence, corporations are passing the risk of rising interest rates onto investors.
The second reason is the uncertainty surrounding the preferential income tax rate accorded to dividends. We would not be surprised if this item in the tax code is sacrificed in the triangular Senate-House-White House negotiations to avert the fiscal cliff. As a preference item, the lower tax rate on dividends is easily positioned by the Democrats as a boon for billionaires. It the lower rate is allowed to lapse, dividends suddenly become more expensive for corporations to pay relative to interest payments on debt. Why? Interest expenses are deductible, whereas dividends are not. The logical treatment is to exempt dividend income from corporate taxes and levy taxes on the recipient. Logic is unlikely to prevail — at least in the short term. Treasurers across the country are using the opportunity to reduce their after-tax cost of capital by swapping equity for debt.
Finally, uncertainty remains rife. Europe remains a mess. No one is really certain what is happening in China. Japan is still in doldrums. Emerging markets do not appear as buoyant. And, stateside, we may through inaction and intransigence push the U.S. economy back into recession. Under most scenarios, aggregate demand is unlikely to expand at a robust pace. If so, buying back shares may prove to be a better way to engineer earnings-per-share growth than building factories, increasing R&D spending or launching new products. In the current environment, reducing the denominator (the number of shares outstanding) is easier to achieve than growing the numerator (net earnings), especially when investors are willing to loan firms the funds at historically low interest rates.
We are always skeptical when corporations use financial engineering to attain earnings growth. This time is unlikely to prove an exception. On the one hand, the incremental debt increases their financial leverage and hence risk; but on the other hand businesses, by lengthening maturities, reduce earnings sensitivity to fluctuating interest rates. Longer maturities certainly afford businesses greater flexibility if global economic growth remains anemic.
Only when we go through the next downturn will we know whether treasurers have trashed the balance sheet or saved their firms from the markets and the whims of investors.
Notes on Sources and Methods:
Net debt issuance covers several different liabilities including corporate debentures, mortgage loans, bank loans, commercial paper and municipal securities (industrial revenue bonds).
All flows are seasonally adjusted.
All data obtained from the Federal Reserve Flow of Funds Accounts for the United States (Z.1) Report released December 6, 2012. Data was obtained from various tables with most obtained from the F.103 table.
(Sources: Federal Reserve Board; AIFS estimates.)