Dr. P.V. Viswanath
IBM, ASML payouts latest red flags for credit market
LONDON, May 31 (Reuters) - Companies are showing ever greater appetite to reward shareholders at the expense of bondholders, with this week's debt-financed payouts by IBM and ASML (ASML.AS: Quote, Profile , Research) the latest causes for bond market concern.
Share buybacks, big dividend payments and a tidal wave of merger and acquisition activity -- set this year to beat the record level reached in 2006 -- all pose threats to company creditworthiness.
But the corporate debt market in Europe has yet to react, with yield spreads at their tightest in at least two years, according to data from Merrill Lynch, and new bond issues being snapped up voraciously -- although investors and analysts warn that this rosy view of the world cannot persist.
IBM (IBM.N: Quote, Profile , Research), the world's largest technology services company, said on Tuesday it was borrowing $11.5 billion and using $1 billion of cash to buy back $12.5 billion of shares, boosting earnings per share but leading to a credit-rating cut.
ASML, the Dutch chip equipment maker, said on Thursday it would pay out 960 million euros ($1.3 billion) to shareholders and would issue its debut bond to help pay for it, in a direct transfer of cash from bondholders to equity investors. "The market is coming to an inflection point," said Simon Ballard, credit strategist at ABN AMRO Asset Management, which has 209 billion euros under management, 36 percent of which is in fixed-income investments.
"One man's meat is another man's poison. But the bond market seems to think that one man's meat is his meat as well," he said, referring to the lack of reaction in prices to the growing tide of shareholder-friendly activity.
"In six months' time, when it starts to filter through the digestive system, the bond market will start to realise that it has been poisoned and that's when we're going to get a correction in spreads," Ballard said. "It's a potential timebomb for the risk-asset investor."
Others too are warning of the growing threat to credit quality.
"Credit fundamentals are deteriorating, with aggregate leverage rising and free cash flow dwindling," analysts at Morgan Stanley said in a note this week, though they noted the deterioration was from a relatively strong position.
"The three-six-month outlook for credit spreads is wider, in our view."
BALANCE SHEET BALANCING ACT
The move by ASML may also signal a shift in European corporate psychology, as shareholder returns in Europe have so far largely been paid for with cash already on the balance sheet rather than directly through new borrowing.
"There is undoubtedly an increased chance of more violent releveraging than in the past," said Matt King, credit strategist at Citigroup.
Shareholder-friendly policies have traditionally been more aggressive in the United States, where CEOs face more active equity investors and are paid more often in stock, while European companies have usually taken a more conservative approach, he said.
But the boom in private-equity M&A activity is placing pressure on CEOs to look at the balance sheet in a new light.
"CEOs are going to get forced into it," King said. "You can't beat the cycle."
Bondholders however face a painful dilemma. With redemptions of euro-denominated corporate debt running ahead of new issuance, they have strong inflows of cash that need to be put to work -- a situation that has helped investment-grade companies price close to 20 billion euros of debt in May.
And while the market remains benign, taking a more defensive posture could prove expensive.
ABN AMRO Asset Management's Ballard said memories of early 2006, when some corporate bond investors had taken bearish positions only to see the market rally throughout the year, persisted.
"The market is very much aware of not being caught offside or being left behind when the party is in full swing," he said. "Until we see a consistent run of more fundamentally bearish corporate data, then people are going to continue to buy into the trend."