Randall Stephenson, chairman and chief executive of telecoms company AT&T (T), which bought Time Warner for $80bn last year, was unequivocal on the company’s recent fourth-quarter earnings call: “Our top priority for 2019 is driving down the debt from the . . . acquisition,” he said.
AT&T, which has over $150bn of bonds outstanding according to Dealogic, is one of many big US companies which spent the years since the financial crisis gorging on cheap debt. As they have done so, they have forgone higher credit ratings and slipped down into the lower reaches of borrowers deemed “investment grade”, which implies a relatively low risk of default.
Now, under pressure from investors, some have started 2019 with a resolution: to get into shape.
Growing debt piles have fed fears among investors that if companies do not start to get a grip on their borrowing, worsening economic conditions could imperil their ability to fund themselves. That could potentially send credit ratings even lower, into the junkyard of “high yield”.
A global survey of investors carried out recently by Bank of America Merrill Lynch (BAC) found that 50 per cent of respondents would rather see companies using their cash to mend balance sheets than spending it on plants or equipment, or returning it via buybacks or dividends. That was the highest percentage since September 2009.
“Now is the time to address balance sheets,” says Peter Tchir, chief macro strategist at Academy Securities in New York. “These companies took full advantage of low interest rates and now they need to focus on deleveraging.”
At a recent investor day, Verizon (VZ) said it trimmed its ratio of net unsecured debt to earnings before interest, tax, depreciation and amortisation from 2.4 times to 2.1 in 2018. The company, which is currently rated BBB+ by Standard & Poor’s, is targeting a ratio of between 1.75 and 2, “consistent with a . . . low single-A credit profile”, according to Matt Ellis, chief financial officer.
Anheuser-Busch InBev (BUD), the world’s largest brewer, issued $15.5bn of bonds in January — the largest bond sale of the year so far. The deal was designed to pay off debt maturing this year, buying the company — rated A- by Standard & Poor’s, four notches above junk — some time to improve its balance sheet. “
This is new territory,” said Neil Begley, an analyst at Moody’s. “We have not gone through a market meltdown with [investment-grade] companies with this much indebtedness.”
The shift is a welcome development for bondholders but could come at the expense of equity investors.
While borrowing costs have been low, companies have used debt to buy back stock and to pay higher dividends. But as attention turns to reducing leverage on balance sheets, analysts warn that some of that equity-friendly activity could slow.
In October, Comcast (CMCSA) said it would stop buying back its own stock over the course of 2019 after its £30bn ($40bn) acquisition of Sky.
Verizon and AT&T both saw their stock prices fall on the day their fourth-quarter earnings were announced this year, while bond prices for both companies rose.
The deleveraging process is “going to be painful for the stock but to the benefit of bondholders”, said Hans Mikkelsen, a strategist at Bank of America Merrill Lynch.
On the more extreme end of the spectrum, AB InBev announced in October that it would be cutting its dividend in half. For most companies, cutting dividends is a last resort — AT&T and Verizon are known for high payouts to stock investors.
“We have strong operational momentum coming out of 2018, and this is going to allow us to reduce our debt and continue our strong record for paying dividends,” said Mr Stephenson on AT&T’s earnings call.
But some companies rated triple-B — the lowest rung of investment grade — have indeed made big cuts to dividends, including Kraft Heinz (KHC) last month and General Electric (GE) last year.
For equity investors, the moral of those stories should be obvious: dealing with debt now may save a lot of bigger problems in the future.
“It’s better to take free cashflows and improve the balance sheet while times are good than to wait for some market-driven phenomenon that may or may not come — but could get in the way of you refinancing debt when it comes due,” said Mr Begley.
High-yield bond investors are also mindful of the risks of these companies failing to reduce their debt and potentially being downgraded further, especially if the economy begins to slow more quickly than expected. “
I am not worried today but depending on the timing of the next recession it could be one of the biggest risks we face down the road,” said Pepper Whitbeck, global head of high yield at Axa Investment Managers.
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