Cheap Money and the Push to Recapitalize America

Includes: DUK, FRP, FTR, IWA, S, T, VZ, WIN
by: Roger S. Conrad

Near-zero interest rates and runaway money supply growth have made the US economy more vulnerable than ever to hyper-inflation and a currency crisis. But little of this free money is flowing into the economy because banks are still more focused on enriching themselves than loaning to customers.

That’s a line that’s being repeated a lot lately in the financial media. And with 2010 elections approaching--and the policies of the Obama Treasury Dept increasingly under fire--odds are we’re going to hear it a lot more in coming months.

Fortunately, it’s a line that leaves out a big part of the equation: strong corporations across the board are borrowing at the lowest rates in half a century. In fact, they’re recapitalizing their balance sheets in a way that will leave them stronger and better positioned for growth than ever.

Several times over the past year, I’ve reported here the shrinking borrowing rates for investment-grade corporations. This month, a unit of Duke Energy (NYSE:DUK) sold $750 million in 30-year bonds at an interest rate of just 5.327%. That was only a 105-basis point premium to Uncle Sam’s taxpayer-funded debt, which itself is selling at the lowest yields in a generation or more.

The spread for 10-year debt issued by A-rated utilities was more than 500 basis points below what it was less than a year ago. Meanwhile, the market for their 30-year corporate debt was virtually non-existent. That steep drop in spreads is a direct consequence of investors’ growing confidence in utilities’ financial health despite what are still difficult economic conditions.

Coupled with the drop in Treasury rates--which is due in large part to easy money--the result is the lowest borrowing rates in decades, precisely when many companies are faced with the prospect of rolling or paying off billions of dollars in debt. And the result will be lower interest costs and easier financing for growth initiatives to build future earnings.

That’s a bullish picture indeed for investment-grade utilities. And it’s a big reason why I’m bullish on the sector’s long-term prospects, even as big-cap utility averages sit roughly halfway between the March 2009 lows and the late 2007 highs.

Duke Energy, for example, is now investing heavily in smart grid technology, wind power and clean coal/carbon capture for its plants. All are set to boost its earnings and dividends robustly in coming years.

The same thing is happening at virtually every other utility in the US as well. But utes are far from the only industry putting today’s easy credit conditions to work for future growth.

A year ago, the market for bonds of sub-investment grade--so-called junk--was not just frozen. It completely vanished. Junk/Treasury yield spreads exploded as high as 15 to 20 percentage points for bonds that could fetch a price.

What a difference a year makes. Since early March Northeast Investors Trust (NTHEX), which owns a diversified portfolio of high-yield paper, is up by more than two-thirds from its March lows, thanks to a mighty rebound in demand for junk bonds. And in fact demand for even the riskiest paper has returned.

Clearwire Corp (CLWR), for example, has been able to raise $2.8 billion in the past several weeks. The funding will go to build a wireless network capable of serving 120 million customers based on WiMax technology. The fact that this network will face vicious competition from the likes of AT&T (NYSE:T), Verizon Communications (NYSE:VZ) and every other major telecom, as well as that WiMax is unproven on such a large scale, seems to have been nearly immaterial to investors.

A year ago, FairPoint Communications (NASDAQ:FRP) was sowing the seeds of its future bankruptcy by borrowing at loan-shark rates to complete the purchase of Verizon rural phone lines in northern New England. In stark contrast, Frontier Corp (NYSE:FTR) has been able to refinance several hundred millions of debt as it prepares for an even larger acquisition of 4.8 million Verizon lines.

That deal may wind up being hung up by regulatory approvals. Public utility commission staffs in Washington State and West Virginia have expressed opposition to the deal on the grounds that Frontier hasn’t proven it benefits consumers. That may indeed delay this deal well into 2010 or even derail it. But one thing is certain: If it is able to complete the deal, Frontier will have nothing close to the crushing debt load that post-purchase FairPoint had by completing the acquisition in the midst of the historic credit crunch.

Last week, Windstream Corp (NASDAQ:WIN) announced another major telecom merger, the $1.1 billion purchase of Iowa Telecom (IWA), including $600 million in assumed debt. The transaction will add 95,000 high-speed Internet customers and 26,000 video subscribers to Windstream’s base, along with roughly a quarter million basic rural phone service customers in Iowa and Minnesota. This deal comes after the purchase of rural phone provider NuVox Communications for $643 million, also announced this month.

When these two deals are completed--probably in mid-2010--Windstream will boast a customer base of 3.3 million access lines and 1.1 million Internet users spread across 23 states. These acquisitions also demonstrate that Windstream, which plans to move its stock listing from the New York Stock Exchange to the Nasdaq, continues to have no problems raising capital, despite a sub-investment-grade credit rating.

It may be some time before recapitalization translates into robust job growth. And the economy may well hit some major turbulence before that, as the US dollar hit a new 15-month low this week against the euro and neared a 14-year low versus the yen.

Gold--historically the best gauge of a particular currency’s absolute value--is at an all-time high against the US dollar, though still barely a third its 1980 high adjusted for inflation.

That’s a direct consequence of the cheap money of the past year. And until the Federal Reserve begins to tighten things up, the dollar will be at risk to further declines, with the likely consequence of either more inflation or higher commodity prices that further crimp economic growth.

Recapitalization, however, continues to be an enormous catalyst for stronger companies and faster earnings growth. That’s a powerful underpinning for this market, despite the challenges it faces.

With the fourth quarter of 2009 more than half spent, it’s clear things have improved somewhat from mid-year, yet probably not enough to ensure positive year-over-year profit comparisons. Businesses that stayed strong during the past two years, however, are now more likely than ever to stay in good shape as the economy works its way back to health.

The overall market continues to respond in basically a two-sided way. On days when the economic news is positive, Treasuries and the US dollar fall and everything else rises. On the days when the news is negative, Treasuries, the US dollar and, increasingly, corporate bonds rally and everything else drops like a stone.

This pattern isn’t likely to change until the economy shows quite a few more positive signs, which isn’t likely to happen until well into next year at the earliest. As long as this trend lasts, however, it means more upside for income investments backed by strong underlying businesses, as perceptions of credit risk are rolled back before inflation risk takes hold. And that’s where our bottom line lies.