The Federal Reserve has committed itself to near-zero interest rates through the end of 2014. US government bond yields are so low that investors are guaranteed to lose money at the mere hint
And yet, corporations have had no trouble issuing debt. Microsoft, for example, filed for its first debt offering back in 2009 when interest rates hit rock bottom. McDonald’s and IBM hit up the debt market in 2010.
These are companies that don’t really
need the money. It’s like a millionaire taking out a loan for ten grand to buy a used car. Part of the blame lies in today’s conservative lending environment. At the height of the housing bubble, you could get a loan without a job or assets. A mere pulse would do. Today, the risk pendulum has swung the other way. Banks are only looking to lend to those who can easily repay the money themselves.
That’s why corporate America has hit the bond market. And with rates incrementally higher than government bonds, it’s easy to see the investor appeal for those with fixed income needs.
Debt is a paradox of investing. It can enhance a company’s returns (and thus maximize share price), but it does so with the risk of bankruptcy if the company falters. A piece of finance theory called optimal capital structure tells us that every company should have some
debt to maximize value, but the total level will vary by industry.
So companies that are issuing debt at low rates and don’t really need to are likely still great investments.
But changing debt levels makes company valuation more difficult. When Ben Graham first articulated the principles of value investing in the 1930s, he looked for companies trading at less than two-thirds of their “liquidation value,” essentially the value of cash and cash equivalents on the book. A tsunami of those opportunities existed in the 1930’s. Today it’s a trickle.
Traditional valuation methods are obscured by debt. Ultimately, investors have to look at a company’s debt load and determine the ability of the company to repay.
There’s another reason for companies to acquire debt, besides today’s low interest rates. American companies with substantial overseas operations are seeing their wealth held hostage by high “repatriation” tax rates.
Yes, companies are sitting on a record $2 trillion hoard of cash. But cash in foreign subsidiaries, which could be used to pay for dividends or share buybacks, would end up taking a 35 percent haircut just to electronically transfer into a domestic bank account. That, like many other things in the tax code, is just plain silly.
Ultimately, debt is a good thing for a company, but only up to a certain point. As investors, our job is to sort through this paradox of debt, and invest in strong companies that use a reasonable amount of debt to minimize their cost of capital and enhance shareholder returns.
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