As more companies try to meet shareholders’ demand for greater buybacks and dividends, firms are dipping into the debt markets to raise cash, potentially fueling risks for investment-grade bonds and related exchange traded funds.
Some companies are borrowing money from the bond markets to assuage shareholders, notably those aggressive activist investors who are pushing for greater value in their investments, reports Robin Wigglesworth for Financial Times.
Consequently, some observers and analysts contend that there is a growing credit risk, and these investment-grade-rated companies run the risk of potential credit downgrades if they continue to borrow, especially with average yields down to 2.8% from the long-run average of almost 7.9%.
“The investment grade space doesn’t look attractive right now, because of tight spreads, the rise of activism and creeping leverage,” Jim Keenan, head of credit at BlackRock, said in the FT article. “Bondholders don’t have the same voice as shareholders, except what we charge.
The potential risks could weigh on the investment-grade bond market and popular intermediate corporate debt ETFs. For instance, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD), Vanguard Intermediate-Term Corporate Bond ETF (NYSEArca: VCIT) and SPDR Barclays Intermediate Term Corporate Bond ETF (NYSEArca: ITR) have been popular plays in an stubbornly low interest rate environment. [Bond ETFs Extend Record Inflows]
LQD has a 8.18 year duration and a 2.91% 30-day SEC yield. CIU has a 6.5 year duration and a 2.87% 30-day SEC yield. ITR has a 4.42 year duration and a 2.17% 30-day SEC yield.
Corporate balance sheets are not as robust as they use to be. According to Moody’s, U.S. investment grade companies at the end of last year held cash equal to 35% of adjusted annual earnings, compared to an average of 43% in 2013 and 51% in 2009. Additionally, the ratio of cash-to-debt has dipped to 14% in the third quarter of 2014, the lowest since 2007.
“Credit quality is beginning to erode,” Robert McAdie, head of research at BNP Paribas, said in the article. “There will be downgrades, not defaults. But we are seeing the virtuous cycle end.
If these companies find it harder to service their growing debt burden, buyback stocks funds, like the PowerShares Buyback Achievers Portfolio (NYSEArca: PKW), and dividend stock ETFs, like the Vanguard Dividend Appreciation ETF (NYSEArca: VIG), could also take a hit since these areas would see cuts first as companies payoff loans. For instance, the energy sector has already cut buybacks and some long-time dividend growers are even considering dividends next in response to the plunge in oil prices. Additionally, after the financial crisis, many banks enacted measures like buyback and dividend cuts to put their houses in order.
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.