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Investing in a Period of Ultra-Low Interest Rates: Part 1 - Dividend/Interest Arbitrage

   Chairman Bernanke's statement today highlights the unprecedented nature of the current economic situation.  The Fed will do "whatever is necessary" to avoid deflation but many observors believe that, with interest rates virtually at zero, there is not much the Fed can do.  The result may be that the Fed will pull very, very hard on those levers it still has available. The Chairman appears to believe that Quantitative Easing will push down interest rates on other securities such as corporate bonds and that the lower interest rate environment will propel the economy forward. 
  Assuming that we are entering into a prolonged period of low short term treasury rates, lower long term treasury rates and ultimately lower yields on investment grade corporate bonds, what are some of the investment implications for the equity market?
  There has been more and more enthusiasm lately for dividend-paying stocks;  for the first time in many years, it is easy to construct a portfolio of high quality dividend paying stocks yielding considerably more than 10 year treasuries. It is also apparent that corporate balance sheets are in relatively strong shape and that large corporations are finding it easy to raise money in the bond market.  This interest/dividend relationship creates opportunities for arbitrage by a number of players. I have posted a piece on my Instablog suggested the creation of Stonds - financial instruments with a guaranteed return of capital at maturity combined with a yield based on the dividends of a group of stocks. Another form of arbitrage is catching on - one investment house is offering brokerage accounts in which dividend paying stocks can be acquired leveraged by loans with interest rates substanially below the dividend yields of the stocks. 
  This piece will deal with the arbitrage opportunites open to the dividend paying corporations themselves. 
  To understand this opportunity, consider a hypothetical corporation with 1 billion shares outstanding priced at $10 a share, paying a dividend of 35 cents a share per annum and earning $800 million or 80 cents a share after taxes. The stock's price earnings ratio is 12.3.   Lets also assume that the corporation plans to increase its dividend so that over the next 5 years it will pay a total of $2.00 a share in dividends(an average of 40 cents a year) and that its effective corporate tax rate is 35%.  Let us also assume a "clean" balance sheet with no debt and an investment grade credit rating.  This picture is not completely atypical in the current market - in fact, a number of large companies have large net cash positions on their balance sheets and similar dividend yields. 
  If the corporation is able to issue 5 year bonds yielding 2 per cent (not a completely unreasonable prospect in the Quantitative Easing environment), the company can substantially improve its after-dividend cash flow and per share earnings by using the money to repurchase its own shares. If the company raises $2 billion in a bond offering and buys back 200 million shares, the immediate effect is cash flow positive to the tune of $44 million a year (interest expense of $40 million minus tax savings of $14 million minus reduced dividend payments of $70 million).  Over the 5 years, the cash flow effect is a positive $270 million.  
  Assuming absolutely no change in revenues or other expenses, the company now has 800 million shares and $774 million in earnings (subtracting the after tax interest expense of $26 million) and so is now earning nearly 97 cents a share (or more than 20 percent more than prior to the "financial engineering"). While it may no longer trade at the 12.3 multiple because it is now somewhat leveraged, it also will have demonstrated per share earnings growth - assuming its PE drops to 12, it will trade at $11.64 a share. 
  Will we see corporations head down this road?  If such buy backs are announced, will stock prices go up in anticipation of this phenomenon?  Will clever corporate financial VPs use downturns in the market to pick up shares at discounted prices?  Will the availability of this mechanism tend to create a "floor" in the prices of blue chip dividend paying stocks?  Is this happening already and does it offer a partial explanation of the seeming disconnect between the solid earnings of blue ship companies and the lackluster performance of the economy?               

Disclosure: Long blue chip dividend paying stocks including JNJ, KO, T, PG.