Debt is no longer chic

Ref The Economist, Feb 19, 2009

In 1980, more than 60 American non-financial companies qualified for the AAA rating from Standard & Poor’s (S&P). Now there are just six. In 1987 just 38.1% of issuers in the American bond market were rated as speculative, or “junk”. In 2007 junk-bond issuers made up most of the market for the first time.

Traditionally, debt has scored over equity in the sense that it reduces the cost of capital, creates tax benefits and most importantly imposes discipline. When managers know they have to pay back the capital they have raised, they will be careful. With equity, this pressure to pay back does not exist.

But as the Economist article explains, managers’ self-interest seems to have taken over at some point. Managers started using cash to buy back equity to boost earnings per share. They also favoured debt over equity to make the share price more volatile, and thereby make the option more valuable. Debt was also often used to finance acquisitions as part of empire building, a rtrend encouraged by investment banks, which had an incentive to recommend debt issuance and acquisitions, to earn fees. While all this was happening, activist shareholders such as hedge funds put pressure on companies to pay out surplus cash.

It is only in the current recession that the dangers of debt are becoming more apparent. The default rate is now rising rapidly. S&P believes that nearly 14% of bond issuers will fail to meet their obligations this year. It is difficult to roll over new debt, given the credit crunch. Meanwhile, suppliers are insisting on instant payment from companies with weak balance-sheets.

The problem for companies is there may not be much they can do right now to rectify the situation. A depressed market is hardly the time to issue equity. Also if an equity issue is announced, the share price tends to fall. For many American companies, the share price is in single digits. And any further fall may have catastrpohic consequences. After all the share price itself is a proxy for default risk as per the well known Merton Model.