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Last Thursday the Federal Reserve published confirmation of a trend we have been seeing for a few quarters, that is, corporate America is taking on marginally less debt and leverage could be moderating. This trend is practically un-American, as corporate leverage has been ticking up for decades!
Moderating leverage is great for corporate bond investors and is one of the reasons why we still like investment grade corporate bonds this late in the credit cycle. In addition to moderating leverage, corporate bonds are benefiting from higher corporate earnings, very high levels of technical demand (as central banks keep interest rates low) and credit spreads that continue to tighten yet are still relatively attractive compared to other fixed income options. We call it the credit Indian summer–great while it lasts.
It is not quite clear what CFOs are thinking and if the recent moderation of leverage is a durable trend. Current beliefs about the optimal corporate capital structure are still widely influenced by Franco Modigliani (a 1985 Nobel Prize winner), whose groundbreaking work with Merton Miller made the argument that corporations could increase their value by substituting debt for equity. Debt is cheaper than equity and interest payments are tax deductible. This academic endorsement of leverage is, we believe, the underpinning to Michael Milken, the rise of the junk bond markets, private equity and LBOs, and perhaps even to the banking crisis of 2008. Pretty influential for a professor!
This early trend of moderation in leverage may nonetheless have legs. Interest rates around the world have likely bottomed, and even slowly rising rates mixed with high leverage is uncomfortable for CFOs. Also, the corporate bond market now has more BBB than A ratings, and the migration from BBB to BB is usually quite painful. The government’s tax reform proposal may reduce or eliminate the tax deduction for debt. And finally, perhaps stock buybacks and dividend increases are losing favor compared to investments that actually grow revenue and income.
Call us old fashioned, or just plain conservative, but we do think it would be very American to grow the value of companies through investments in productive assets, people and processes all funded with cash flow, rather than just increasing stock values with the use of leverage.
Source: The Wall Street Journal, The Federal Reserve, Bank of America Merrill Lynch