Amid the fallout of the General Electric Co. debacle, a delicate but crucial social contract between shareholders, bondholders and Corporate America is being quietly redrawn.
For a decade since the financial crisis, U.S. companies have piled up debt to fund generous equity buybacks, helping supercharge a fourfold jump in the S&P 500 Index in the process.
But as scrutiny on company financial health mounts, creditors are seeking to wrestle back control and curb these balance-sheet-be-damned maneuvers.
Already, U.S. companies are curtailing the amount of bonds sold to buy back their own stock by a third in 2018, based on a Bloomberg data search of transactions detailing use of proceeds. In Europe, where it’s more unusual for companies to borrow to redeem stock and profitability has recovered more slowly, issuance is running at an eight-year low.
It all points to a reversal of the type of shareholder-friendly activity that propelled the S&P 500 to dizzying peaks this year. Companies need to shore up their leverage before an economic downturn hits, as well as court lenders they may need down the road. And as interest rates grind even higher, treasurers are likely to think even harder about borrowing to enrich shareholders.
“It’s a different calculus in this environment,” said Joseph Elegante, a money manager at UBS Asset Management. “We’re going to see a lot more discipline. We’ve absolutely seen share prices react to higher levels of leverage.”
Yields on U.S. investment-grade corporate bonds trade at 4.35 percent, their highest in more than eight years, according to Bloomberg Barclays indexes. This level is also higher than the benchmark’s average coupon, which means that new corporate bonds will be more expensive than existing debt.
For Fidelity International fund manager Bill McQuaker, GE was the watershed moment.
The blue chip had AAA ratings on par with the U.S. Treasury from Moody’s Investors Service in 2009. Now, it’s been forced into fire sales to shore up its rating as yields shot up to near junk levels.
“If the credit markets are now a bit more nervous about that run of events, if their willingness to fund companies’ appetite for credit isn’t as great as it was, we need to worry about that,” McQuaker said at a Nov. 27 briefing in London. “One of the biggest positives for the U.S. market ever since 2009 has been companies that have been happy to use cash to buy back equities.”
Since the S&P 500 bottomed out in 2009, its constituents have splashed $4.7 trillion on buying back shares and $3.4 trillion on dividends, data compiled by Bloomberg show.
The leverage binge that helped fuel such activities pushed about half of outstanding investment-grade bonds into BBB ratings ranks — setting them up as candidates for fallen angels in the next downturn. For high-grade companies in 2017, debt outstanding relative to an earnings measure was at its highest level since at least 2010, according to Morgan Stanley.
Of course, low borrowing costs aren’t the only reason behind the buyback boom. Companies building up cash piles from growing profits may still prefer repurchasing shares to investing in the business. Even as rates rose, the second quarter of 2018 still marked a record for buybacks on the S&P 500 in the post-crisis period, and the amount only dipped slightly in the following three months.
Moreover, the U.S. tax break means there’s less need for large cash-rich firms to issue debt to fund such programs.