Bond Binge Expands Leverage Toward Financial Crisis Peak

Bond Binge Expands Leverage Toward Financial Crisis Peak

Company debt loads in the U.S. are approaching the highest level since the aftermath of the financial crisis as borrowing to finance mergers and shareholder payouts exceeds earnings growth.

Debt levels have increased faster than cash flow for six straight quarters, boosting the obligations of investment-grade companies in the second quarter to 2.09 times earnings before interest, taxes, depreciation and amortization, according to JPMorgan Chase & Co. That’s up from 2.07 times in the first three months of 2013 and compares with 2.13 in the third quarter of 2009, when it peaked after the deepest recession since the Great Depression.Businesses from Apple Inc. (AAPL) to Comcast Corp. (CMCSA) have tapped credit markets this year to take advantage of the lowest borrowing costs on record before the Federal Reserve decides to pull back on measures intended to boost an economy that’s forecast to expand this year at the slowest pace since 2009. The leverage trend can’t be sustained, JPMorgan analysts led by Eric Beinstein wrote last week in a report, and a combination of rising rates and high cash balances may curtail issuance.

Risks Exposed

“They are stretching their metrics and leaving themselves exposed to the risk that there isn’t a full-scale recovery,” Rajeev Sharma, who manages $1.5 billion of fixed-income assets in New York at First Investors Management Co., said in a telephone interview. “Once rates start to spike up, you should see less new issuance and some kind of normalization” in leverage, he said.

Investment-grade companies have issued $739 billion of bonds in the U.S. this year, according to data compiled by Bloomberg. That’s a faster pace than in the same period of 2012, when a record $1.12 trillion of securities were issued by borrowers ranked Baa3 or higher by Moody’s Investors Service or at least BBB- by Standard & Poor’s.

While earnings growth has remained limited, “there has been no moderation in the pace of debt,” the JPMorgan analysts wrote in an Aug. 23 analysis of 190 non-financial companies. Borrowings increased by 9.1 percent in the quarter ended June 30 from a year earlier, rising to a decade-high of $2.9 trillion even as Ebitda dropped 2.3 percent, led by declines in the metals and mining industry.

Credit Benchmarks

“A lot of debt issued in the last year has been to finance mergers and acquisitions and rewarding shareholders,” said the analysts, whose New York-based firm underwrites the most corporate bonds worldwide. Those trends “seem to be declining” and “we expect that companies will reduce the rate of debt issuance due to rising yields and high cash balances,” they wrote.

Elsewhere in credit markets, the cost to protect against losses on U.S. corporate bonds jumped the most in more than two months as tension increased over possible military action in Syria. The World Bank’s International Finance Corp. sold $3.5 billion of five-year notes. S&P cut the credit rating of Playboy Enterprises Inc., four months after the men’s magazine publisher got $185 million in loans.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, rose 4.4 basis points to a mid-price of 83.9 basis points, the biggest increase since June 20, according to prices compiled by Bloomberg.

Syria Tension

The U.S., France and the U.K. stepped closer to a military strike against Syria, laying the legal groundwork to justify action, moving forces into place and rounding up allies in the region.

The Markit iTraxx Europe Index of credit-default swaps tied to the debt of 125 companies with investment-grade ratings fell 1.8 to 106 at 9:38 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan rose 1.4 to 170.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.37 basis point to 17.88 basis points, the lowest since Aug. 15. The gauge typically narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

IFC Offering

Bonds of Fairfield, Connecticut-based General Electric Co. were the most actively traded dollar-denominated corporate securities by dealers yesterday, accounting for 2.9 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

IFC, the private-sector arm of Washington-based World Bank, sold 1.75 percent of securities due in September 2018 at an issue price of 99.952 cents on the dollar, Bloomberg data show.

The S&P/LSTA U.S. Leveraged Loan 100 Index fell 0.02 cent to 97.64 cents on the dollar, the ninth straight decline and the lowest level since July 9. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 2.93 percent this year.

Playboy Ratings

Leveraged loans and high-yield, high-risk, or junk bonds are rated below Baa3 by Moody’s and lower than BBB- at S&P.

Playboy’s corporate credit rating was cut one level to CCC+ from B-, and the grade on its senior-secured debt was lowered to B-, the New York-based ratings firm said. Playboy is at risk of violating covenants in its financing pact related to its interest expense relative to earnings that may crimp its ability to access its $10 million revolving credit line, S&P said.

In April, the Beverly Hills, California-based company had lowered the rate on a $185 million first-lien loan maturing in 2017, Bloomberg data show.

In emerging markets, relative yields widened 9 basis points to 373 basis points, or 3.73 percentage points, according to JPMorgan’s EMBI Global index. The measure has averaged 304.2 basis points this year.

While an economic recovery in the U.S. following a 2.8 percent contraction in 2009 helped companies improve their finances and lower leverage to a ratio of 1.83, credit metrics have since deteriorated, according to JPMorgan data that excludes automakers.

Economic Forecasts

Gross domestic product in the world’s largest economy will expand 1.6 percent this year after a 2.8 percent increase last year, according to the median estimate of 73 economists surveyed by Bloomberg.

Comcast has issued about $7 billion of bonds this year, $4 billion of which helped finance a $16.7 billion payment to General Electric for its remaining stake in broadcaster NBCUniversal. The largest U.S. cable provider’s debt-to-earnings ratio has since climbed to 2.25 at the end of June from a more than decade-low of 1.94 a year earlier.

“We view our balance sheet as a strategic asset and are focused on strengthening our financial position over the next few years with a medium-term leverage ratio target of 1.5 to 2 times,” Michael Angelakis, Comcast’s chief financial officer, said on a July 31 conference call with analysts to discuss second-quarter earnings.

Apple Leverage

Apple, which is paying shareholders $100 billion to compensate for a stock that’s been hammered by signs of slowing growth, sold $17 billion of bonds in April, the biggest corporate offering on record. That added leverage to a balance sheet that had been debt-free since 2003.

It also lifted the total amount of cash delivered to shareholders in the second quarter by investment-grade companies to $485 billion, a 1.5 percent increase from the previous period, JPMorgan data show. That’s 57 percent higher than the average over the past decade, though the level has declined from a year earlier, the analysts wrote.

“As companies are less and less able to deliver earnings growth through internal efficiencies and top-line growth, and at the same time shareholders are pushing for increased rewards, they’re turning to financial engineering to push returns,” said Alan Shepard, an analyst and money manager at Madison Investment Advisors Inc., which oversees about $16 billion in Madison, Wisconsin. “Borrow the money at low rates to finance repurchases and you can drive earnings-per-share growth.”

‘New Norm’

Steve Dowling, a spokesman at Cupertino, California-based Apple, didn’t respond to telephone and e-mail messages seeking comment on the company’s finances.

“People have been forced into accepting that lower credit quality is the new norm,” said Robert Smith, the chief investment officer at Austin, Texas-based Sage Advisory Services Ltd., which oversees about $10.5 billion.

While heavier debt burdens have been supported by a Fed policy that pushed average U.S. corporate-bond yields to a record-low 2.65 percent in May, JPMorgan strategists said they expect issuance to slow as interest rates increase. Speculation is mounting that Chairman Ben S. Bernanke will reduce the central bank’s $85 billion in monthly debt purchases as soon as next month.

With a greater sense of urgency to tap debt markets before rates climb higher, companies may continue to increase leverage through the end of the year, Bank of America Corp. debt strategist Yuriy Shchuchinov said in an Aug. 26 note.

The Fed speculation helped lift borrowing costs to 3.5 percent through Aug. 26, according to the Bank of America Merrill Lynch U.S. Corporate Index. That’s still more than 2 percentage points less than the 5.9 percent average over the last 20 years.

“As the yield curve continues to move higher, companies may be more reluctant to increase leverage to reward shareholders,” Shepard said. “Eventually the debt has to be refinanced or retired, and the odds are that it won’t be done at the historical low rates of earlier this year.”

To contact the reporter on this story: Charles Mead in London at cmead11@bloomberg.net