Bondholders feel the strain

Buoyed by healthy balance sheets and cash reserves, corporate America is preparing to reward its shareholders with increased dividends and share buybacks. But as Saskia Scholtes reports, the prospect of such activity is worrying bondholders

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Corporate bond investors have been riding high for the past few years. Credit quality has steadily improved, default rates have fallen dramatically and once-neglected balance sheets have been patched up. Rating downgrades still outpaced upgrades on US corporations in 2004’s second quarter but only by the narrowest of margins, and through a combination of cost cuts and profitability gains, corporate America’s cash reserves have seen remarkable growth.

Unfortunately for bondholders, however, the corporate credit recovery has not escaped the notice of shareholders, who are eying this excess cash in the expectation of increased or special dividend payments and share buybacks. And some investment-grade issuers are already marching to the equity market tune. The summer saw companies such as Clear Channel Communications, Liberty Media, Citizens Communications and Microsoft putting excess cash to work for their shareholders—a development that some fixed-income analysts are calling the beginning of the end for the golden age of being long credit.

Greg Peters and Rizwan Hussein, credit strategists at Morgan Stanley, said in a recent report that such equity-friendly news is unequivocally negative for corporate debt holders and that “corporate bond investors may have to go from popping open Cristal champagne to screw-opening Two-Buck Chuck. To us, the current unlocking of shareholder value will sow the seeds of future balance sheet ruin.”

According to Peters and Hussein, the danger is that if companies who pay out special dividends and buy back shares also experience immediate improvement in their stock prices, “this will serve as the green light for the rest of corporate America to hop on board the equity culture train.” And they may do so despite the fact that sustaining the improvement may prove difficult and that companies which pay out cash in outsized special dividends and share buybacks may find that their cost of capital actually increases.

However, while many analysts agree that there has been a perceivable shift in corporate focus away from bondholder concerns and back to equityholders, few anticipate that the balance sheet ruin Peters and Hussein describe is imminent. Michael Buchanan, head of US credit products at Credit Suisse Asset Management, points to the fact that improvements in credit fundamentals continue to make progress, adding, “The move towards more equity-friendly activity is certainly one indicator of a change in the credit cycle, but the markets are not that quickly derailed. Credit cycles don’t turn around on a dime.”

According to figures from Moody’s, a recovering global economy and easier access to financing have steadily pushed corporate defaults lower. At the end of July, 23 bond issuers had defaulted on about $6.8 billion of bonds, roughly half the pace seen in 2003. And the rating agency expects defaults to continue falling until mid-2005.

At the same time, says John Bilardello, head of global corporate ratings at Standard & Poor’s, bondholders have little historical precedent to expect excess cash to be used for their benefit—one reason why Standard & Poor’s rarely subtracts cash balances from company debt totals since there is no certainty that cash will not fly out of the door for another purpose. “Corporate business strategy is not to manage for upgrades. From a credit standpoint, companies tend to focus on maintaining their current ratings and outside of that, decisions are based on how best to reward their shareholders. So it was somewhat inevitable that corporate America would start to return some of its cash hoard to equity investors.”

Bondholder loss

Nevertheless, equity-friendly activities can weigh heavily on bondholder fortunes. One recent example is Citizens Communications’ special dividend announcement in July. While Citizens’ stock shot up more than 12%, spreads on its debt widened by more than 100 basis points and the company was downgraded to junk by both Standard & Poor’s and Moody’s. In the case of Moody’s, the downgrade was by three notches from Baa3 to Ba3 with a negative outlook, based on the more aggressive fiscal policies being undertaken by Citizens’ management.

Eric Geil, telecom analyst at Standard & Poor’s, says, “The downgrade is based on the concern that Citizens’ initiation of a substantial dividend, indicating a distinct shift toward a more shareholder-oriented financial policy, will limit further deleveraging and reduce the company’s financial flexibility. The smaller resulting financial cushion might hamper Citizens’ ability to address rising competitive pressure on its mature local telephone operations.”

Elsewhere, wider spreads were triggered by the news that Cox Enterprises plans to acquire the outstanding publicly held 38% interest in its subsidiary Cox Communications, for $7.9 billion in cash. Cox’s share price lit up, but some of its bonds choked on the potential increase in leverage and both Moody’s and S&P placed Cox Communications’ Baa2/BBB ratings on review for downgrade.

Notwithstanding the widening in spreads and cost of default protection on existing debt, Pamela Stumpp, chief credit officer in the US corporate finance group at Moody’s, explains that shareholder-friendly transactions that bring about downgrades to junk are particularly worrisome for bondholders because bond indentures issued by investment-grade companies tend to include very little covenant protection for investors. This means that the newly junked company may be able to incur debt at a more senior level in the capital structure and create structural subordination for the existing noteholders.

So while Peters and Hussein at Morgan Stanley argue that companies pursuing regular, steady and moderate dividends would support bondholder-friendly business models, they say, “The recent turn in tone cannot bode well for credit investors.”

Don’t panic—yet

However, analysts point out that bondholders need not fear a credit crisis just yet. Very few of the recent shareholder-friendly transactions have had a transforming impact on company balance sheets, since many companies are using free cashflow to step up dividends or buybacks. At the same time, what activity there has been is thus far largely constrained to the cable and media sectors. John Tierney, credit strategist at Deutsche Bank, says that outside of the cable and media sectors, many companies so far are simply exercising existing share buyback programs and not necessarily raiding the corporate piggy bank to return cash to shareholders.

In terms of which sectors could pose a risk to bondholder fortunes, a recent report by Citigroup credit strategist Dennis Adler says, “We are beginning to believe that sectors that have accumulated cash on their balance sheets and do not have any immediate plans to increase capital expenditures are a risk for bondholders. It is as if they have money burning a hole in their pockets in a low interest environment and are looking to use it to help their stock prices.” So while these companies may look attractive from a deleveraging basis, they are more likely candidates for hurting bondholders.

Peters and Hussein at Morgan Stanley agree, particularly in cases of companies that have also seen their equity prices lag. By looking at companies with a high level of cash relative to debt and struggling equity prices, Peters and Hussein found several potential candidates for cash-burning, shareholder-friendly actions. These include Hewlett-Packard, with 202% more cash than debt and 12% loss on equity for 2004, and pharmaceutical company Wyeth, with 70% cash relative to debt and a 16% loss on equity for 2004.

With the amount of cash covering debt having reached record highs, it is certainly the case that CFOs will come under increasing pressure to allocate it, whether to increased capital expenditure, M&A activity, share buybacks or paying down debt. Analysts point out that corporate America tends to be quite conservative in the early stages of recovery and indeed some of these activities could benefit bondholders if applied correctly, but the current shift in attitudes could mark a corporate environment in which bondholders start to fall by the wayside.

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