BY HIS own account Christopher Hitchens, an author who died in 2011, was a poor student. He left Oxford with a third-class degree. This was not for want of ability. Hitchens
would become a prolific essayist and fearsome debater. Rather, it was a choice. His tutors warned him about neglecting his studies. But he preferred to divide his time between his social life, political protests, books (other than the prescribed ones) and lively debates with other thinkers.
As Hitchens’s counterexample demonstrates, it is possible to regret the opportunities missed while striving for top grades. It is a lesson that many of America’s biggest companies have grasped. At one time, the sort of company that could tap the bond market for capital would be given an A-grade as a matter of course. These days the typical corporate-bond issuer has a credit-rating of BBB, only a notch above a junk rating (see chart).
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That might seem to imply that business has become less efficient or lucrative. Yet profits have never been higher as a share of GDP. In fact, for much of corporate America a BBB rating is the consequence of a financial strategy. Many established firms have chosen to load up on debt to buy back their own shares in order to boost shareholder returns or, more recently, to pay for mergers.
To understand why, it helps to start with a bit of textbook finance that says share buy-backs are pointless. According to a theory proposed in 1958 by Franco Modigliani and Merton Miller, a firm’s capital structure—its mix of equity and debt finance—has no effect on its value. Debt has first call on profits; shareholders get what is left over. Debt is thus less risky for investors and a cheaper form of finance for companies. The more debt a firm has, the more volatile are its equity returns. Investors dislike volatility. So a firm’s share price should in principle decline as it takes on more debt, leaving its overall financial value (the sum of its debt and equity) unchanged.
The theory simplifies reality to illustrate a truth—a firm’s worth is ultimately its cashflows. In the real world, there are benefits to using debt. A big one is that interest costs are tax-deductible. This tax shield is in effect a subsidy to debt finance. Debt also has costs. A high interest burden can lead to missed opportunities or a damaging bankruptcy. Each firm has to make a trade-off between the costs and benefits. Capital-goods firms may plump for low debts and a solid credit rating to show they will be around to honour their warranties. Telecom companies, which have more stable earnings, are more likely to gear up.
As the corporate-bond market has expanded, new categories of firms have been able to take advantage of cheap debt finance. The taboo on issuing lower-grade debt became weaker in the 1980s after “corporate raiders” used junk bonds to finance leveraged buy-outs of listed companies. Since the financial crisis corporate-debt issuance has accelerated, says Adam Richmond, an analyst at Morgan Stanley. Low yields on government bonds as a result of quantitative easing have drawn investors into riskier sorts of paper. Companies have seized on this demand as a further subsidy to debt. The number of firms issuing bonds has increased by two-thirds in the past decade, according to PIMCO, a fund manager.
No doubt some firms will discover they have issued too much. It is of some comfort that the ratio of corporate debt to GDP is barely higher than its previous cyclical peaks, in 2000 and 2008. Bond finance has in part displaced bank finance. But if banks are less exposed, investors are more so. For now, strong GDP growth is a balm. A recent report by S&P Global, a credit-rating agency, plays down the risk of a rash of downgrades to junk. Firms might simply choose to buy fewer of their shares back to preserve their BBB rating.
Even so, a recession will come sooner or later. The profits of leveraged firms will be damaged, which will in turn hurt confidence. Downgrades and defaults will follow, as they always do. The process will be more drawn-out than usual if, as seems likely, there proves to be a shortage of buyers for a fresh supply of junk.
For now the market is stable. But corporate credit is an asset class to be wary of in a maturing economic cycle. In good times there seems little prospect that buyers might dry up. But they will. The best time to buy corporate bonds is early in an economic recovery, when downgrades and defaults are still under way. There are likely to be more bargains than usual next time. If companies no longer need to strive for an A-grade, all the more reason for investors to do their homework.