Last Year was a year in which holders of both corporate debt and equity enjoyed outsized returns. It hasn't always been so. In the late 1990s at the height of the equity market bubble, corporate bond spreads were already well into a widening trend, reacting to balance sheets that became ever more strained to fund the activities that were keeping the equity boom alive. The pace of stock buybacks and merger and acquisition activity were not the only things driving stocks higher, but they were contributing factors and were typical of a period when bondholder interests were largely subordinated to those of equity holders.
Only when the bubble finally burst was the shoe on the other foot and equity investors were relegated to the bottom of the pecking order as management teams struggled to cut costs, conserve cash and bring over-levered balance sheets back into line. The degree of overhang from the bad behaviors of the boom years made for mixed results in each asset class in 2001 and 2002, but a rebounding economy in 2003 proved to be the savior of previous years. Last year ended the bear market in equities, but it also ended the bull run in interest rates and looking forward, it is possible that the interests of debt and equity holders are once again diverging.
This may seem to be a counterintuitive thought, given the degree to which a rising equity market helps bondholders. Equity rallies usually go hand in hand with economic upswings, so operating conditions are generally improving even as a rising market cap benefits credit ratios. The result is an overall improvement in credit metrics such as has been seen in the last 12 months. Another positive is that last year's strong performance from equities is certain to foster a more-receptive market for equity issuance in the coming year. The lack of appeal in issuing equity at seemingly depressed valuations has been one of the factors spurring the heavy corporate debt issuance in recent years, particularly in the high-yield sector.
While the bond market has been well able to absorb the high volume of issuance in the past three years without pressuring spreads, the potential to rely more heavily on equity financing in the coming year comes at an opportune time. Interest rates are still at comparatively low levels but the long rally in yields is now behind us. A major factor that has allowed the market to be so sanguine about taking down large chunks of debt has been that bonds were the investment du jour once the bloom fell off the equity rose and a substantial reallocation of funds threw a wall of money at the available supply. That trend has been stopped in its tracks in recent months.
There are other developments that are worth watching. M&A activity is once again on the rise. Another issue worth noting is likely to be the purpose to which excess cash is directed. For the past several years, bondholders have held sway here and the religion of debt repayment has been ascendant. But with corporate profits recording 14.5% annualized gains (to the end of the third quarter), ratings stabilizing and the bond market willingly lending across the credit spectrum, shareholders have become more persistent in their call for available cash to be directed to dividends. And, prompted by recent tax changes, companies are listening. The trend of increased dividends is definitely on the rise, sometimes as a substitution for previously high levels of stock buybacks and sometimes in addition to ongoing buyback activity.
The implications for bondholders vary across different sectors and often hinge on whether the stock is viewed to be a growth stock or a value stock. Given that we are still relatively early into this profit and credit recovery, most management teams seem to be treading cautiously at this point and looking at any moves to direct more cash to shareholders with an eye on both the likely reaction by the rating agencies and a desire to maintain a degree of financial flexibility. This is good news for bondholders given that the degree to which bond pricing has tightened has well outstripped the degree to which credit quality has improved. Unfortunately, these trends are cyclical, and we will likely see an erosion of this sensitivity as we move further into the recovery and the credit upswing. After all, not many management teams get paid in bonds.
Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.