SMSFundamentals | Jul 15 2020
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As low interest rates have underpinned borrowing, corporate debt issuance has surged and, Janus Henderson Investors highlights, these instruments can provide more certain returns compared with shares
-Low interest rates and central bank stimulus pushed net debt up sharply
-2020 presents opportunities to invest in corporate bonds
-De-leveraging cycle looming in Australia
By Eva Brocklehurst
Company resources, depleted by debt-financed acquisitions, large share buybacks and record dividends are now being confronted by rising trade tensions and an economic slowdown.
Low interest rates have underpinned borrowing in recent years and central banks have attempted to stimulate sluggish economies. This is the background, Janus Henderson Investors asserts, which pushed net debt up sharply in 2019.
Now, as a global recession unfolds, profit and cash flow will be lower and more borrowing will be required. Much will depend upon the extent to which new borrowings are spent or held as reserves, and how much in the way of shares is issued to bolster balance sheets.
Gearing, a measure of debt relative to shareholder finance, rose to a record 59% in 2019, while the proportion of profit devoted to servicing interest payments also rose to a new high. However, there were few signs of corporate stress, that is, until 2020 arrived and coronavirus struck.
Janus Henderson has found companies in its Corporate Debt Index owe half their debt in the form of listed bonds. Corporate bonds typically offer higher rates of interest compared with savings accounts or government bonds and still offer more certainty of returns compared with shares.
While typically riskier than government bonds, the diversity of corporate issuance means investors can select a risk profile that suits them and for a term that matches their preferred investment horizon.
An additional US$557bn was issued in bonds between January and May. Companies are now rushing to issue new bonds and borrow from banks to ensure there is enough cash to endure any second wave of the coronavirus crisis.
The analysts suspect, as central banks continue to provide support, those companies that previously took emergency government hand-outs during the worst of the pandemic may now take the opportunity to reduce reliance on the state. As a result bond issuance is likely to rise further.
The most indebted company in the world is Volkswagen, (there are five car makers in the global top 10) with Janus Henderson assessing that company's net borrowing is not far behind the sovereign debt of South Africa or Hungary, although this is inflated by a large car finance business.
At the other extreme, one quarter of the companies in the index have no debt at all and some have vast cash reserves. Atop this category is Google's owner, Alphabet. However, the analysts point out, a large cash cache is often unpopular with shareholders.
Bond Investment Opportunity
For investors in bonds, Janus Henderson believes 2020 presents opportunities to invest in companies that have the ability to repay debt in a low interest rate environment.
Importantly, the analysts will be looking for signs a company is able to strengthen its position when conditions improve and use surplus cash to pay down debt rather than spending it, or even issue new shares to balance the financing risk between equity and borrowing. This pushes bond prices up and generates capital gains for investors.
Outside of the US, dividends rather than buybacks play a greater role in returning capital to shareholders. Morgan Stanley has estimated that US companies are around four times more likely to buy their own shares because of favourable tax treatment. As a rule, equity finance is more expensive than debt, although most companies use a mix.
From an industry perspective, utilities which have stable earnings support the highest debt levels. The analysis shows utilities are spending US$4 in every US$10 of operating profit on interest or over 2.5x as much as other companies. However, in June, bond yields for utilities in the index were slightly below the average and have fallen despite very high debt levels.
Meanwhile, the fastest growth in debt has come from the aerospace, pharmaceutical and media. The analysts acknowledge this is distorted in the case of the latter by internet giants with vast sums of cash such as Facebook and Alphabet.
In the rest of the media sector rising demand for content, acquisitions and buybacks has pushed sector debt up by US$120bn since 2014. Netflix accounts for a large portion of this increase as it invests in new programming.
The analysts also point out oil producers, while asset rich, do not hold the most debt because profits can quickly disappear when oil prices fall and interest must still be paid. The mining industry, albeit smaller, has also very similar borrowing characteristics and cyclical reasons.
The analysis indicates Australia has forged its path of indebtedness and is more typically associated with higher borrowing levels compared with its neighbours in Asia, where there is a cultural aversion to debt. Nevertheless, Australia has lower levels of corporate debt compared with the rest of the developed world. Net borrowings in Australia have fallen to $87bn in 2019 from $124bn in 2014.
In Australia, a de-leveraging cycle is looming and debt-to equity ratios have fallen markedly. If this continues, Janus Henderson suggests it may represent a once-in-a-decade event for credit markets. Australia's most indebted companies are Telstra ((TLS)) and Transurban ((TCL)).
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