Analysis: Rise of shareholder activism gives bond investors headaches
By Steven C. Johnson and Jennifer Ablan
NEW YORK (Reuters) - When shareholder activist Carl Icahn turned up the heat on Apple in October, demanding a massive $150 billion share buyback, bond investor Bill Gross wasn't having any of it.
Gross, the co-chief investment officer of Pimco, which runs the world's largest bond fun, took to Twitter, saying: "Icahn should leave Apple alone & spend more time like Bill Gates," referring to the Microsoft chairman now famous for his philanthropic efforts.
The aggressive brand of investor activism that irked Gross is starting to unnerve other bond investors.
Activist targets such as Apple Inc (AAPL), Chesapeake Energy Corp (CHK), Sotheby's (BID) and Safeway Inc (SWY) have all seen stock prices rise this year, netting tidy rewards for their largest shareholders.
But bond investors fear the pressure on companies to return cash to shareholders has prompted them to take on more debt, which can erode credit quality and potentially saddle bondholders with losses.
Some fear it is a precursor to a surge of debt-financed buyouts, which can turn steady, investment-grade assets into "junk" credits while shareholders reap big gains.
"Activist shareholders are rarely good news for bondholders. The types of programs advanced typically involve enhancing equity returns to the detriment of a company's overall credit quality," said Bonnie Baha, head of the global developed credit group at DoubleLine Capital in Los Angeles.
Rock-bottom interest rates have made it easy for companies to engage in "financial engineering," borrowing to finance buybacks and dividends, making per-share earnings look better for shareholders while reducing balance sheet quality.
Through September of this year, 21 percent of corporate bond deals referenced "share repurchases" in the "use of proceeds" section, more than double the amount for all of last year, according to Deutsche Bank.
Buyback authorizations for the nation's biggest companies are at levels not seen since 2007. Through December 17, S&P 500 companies had authorized $475 billion in share buybacks, according to Thomson Reuters data.
In some cases, companies' borrowing costs are below the dividend yield on their stock. Low rates have facilitated the debt-laden purchases of Dell and H.J. Heinz - both of which had their ratings cut to junk - and have ensured a steady stream of yield-starved bond investors eager to finance such buyouts.
Verizon Communications (VZ) had no trouble finding takers for a record $49 billion bond offering in September to finance its $130 billion buyout of Verizon Wireless.
No wonder Icahn said after his publicly traded investment company, Icahn Enterprises L.P. (IEP.O), reported strong third-quarter earnings, "There has never been a better time than today for activist investing.
Shares of Icahn Enterprises have risen 161 percent this year.
According to Activist Insight, a UK-based company that tracks activist shareholder activity, such investors targeted 138 companies around the world through October and are likely to beat last year's total of 145 by year end.
Things look different from bond investors' point of view. Rumors earlier this year that prominent activist Bill Ackman of Pershing Square might have taken a big stake in FedEx Corp (FDX) was enough to boost shares by more than 4 percent.
The company's bonds, however, suffered losses that pushed their yields up by about 20 basis points over comparable Treasuries, scaring investors, said Thomas Graff, fixed-income portfolio manager at Baltimore-based Brown Advisory, which manages $40 billion.
Bond yields move inversely to price. Higher corporate bond yields suggest greater risk of a ratings downgrade or default.
The biggest fear for bond investors is a rerun of the sort of leveraged buyout boom that began in the mid-2000s when interest rates were low. Back then, deals such as those involving Clear Channel Communications, Chrysler LLC and Texas utility Energy Future Holdings Corp - the largest private-equity buyout ever - all ran into trouble, leading to distressed-debt exchanges, bankruptcy or both.
"This is a play we've all seen before," said Graff. "The market gets accommodative, companies boost leverage and default rates and ratings downgrades rise."
Things haven't heated up that much yet. But there are signs that anxiety is rising. Broad investment-grade indexes show corporate bonds yielding just slightly more than a percentage point above comparable Treasuries, but those spreads are wider in select sectors, including telecom and media.
Bonds from cable operators, investors say, have seen prices slide and spreads over Treasuries widen by an additional 65 basis points or so on speculation that Time Warner Cable (TWC) could become the subject of a takeover bid. If a leveraged buyout was to occur, the company's credit ratings would likely suffer and existing bondholders would face losses.
A repeat performance of the mid-2000s is not certain. Analysts at U.S. Trust pointed out in a recent note to clients that an uncertain outlook for the U.S. economy may act as a brake on LBO activity as it did in 2013.
Still, to protect themselves, bond investors stressed the need to analyze companies more deeply before deciding to lend to them. Laggards with slow growth or stagnant stock prices may become targets in 2014 of activists eager to shake things up.
"It's a big concern "because they're going to do it in a way that benefits equity and hurts bondholders," said Diana Monteith, a fixed-income manager at Loomis Sayles, which manages $195 billion. "It's rare that it's positive for an investment-grade bond"
It's not just underperformers that have had to fend off outside pressure. Icahn tried to pressure Apple, the most valuable U.S. company, to conduct $150 billion in share buybacks. That was on top of a previously authorized $60 billion buyback partly financed by selling $17 billion in debt. Icahn later reduced his demand to $50 billion.
The decision to take on more leverage makes sense for some companies, said Rick Rieder, co-head of fixed income for the Americas at BlackRock.
"If you are running at low levels of leverage and you can continue to finance yourself and your cash flow is robust, you can take on incrementally more leverage. From a debt holder's point of view, I don't have a problem with that," he said.
"So you're going to see more shareholder activism, similar to what's happening with Apple, because it's so inexpensive for companies to finance themselves."
The surge in activism comes against the backdrop of a roaring stock market; including dividends, the S&P 500 has delivered a total return of 27.5 percent this year and 43.5 percent since 2012 (.SPXTR).
If those gains slow as expected in 2014, pressure from activist hedge funds eager to squeeze out returns from poorly run companies could increase. That could get more difficult if interest rates rise as well.
"I think a lot of the easy money has been made in the stock market," said Monteith. "Making broad equity bets may not be as safe as it was, so (activists) will look for something that's underperforming and see if they can change it." (Reporting by Steven C. Johnson and Jennifer Ablan; Editing by Leslie Adler)