Instajunk

Marilyn Cohen, Forbes Magazine, 03.13.06

The scream of pain and anguish you hear is coming from bondholders. We are suffering from a mania that is sweeping corporate America, benignly called “enhancing shareholder value.” The most common form of this phenomenon is the stock buyback, which if perpetrated on any but the highest-P/E companies has the effect of increasing earnings per share and perhaps the stock price. Unfortunately, at the same time that buybacks enrich shareholders they impoverish bondholders. To pay for the shares the corporate treasurer must either deplete cash reserves or borrow money, and either action hurts a company’s credit rating.

Joining buybacks as credit-quality killers are the new zest for acquisitions, which add punishing debt, and spinoffs, where good units depart and big liabilities stay. Whether such moves are strategically wise or not, they frequently have one bad effect: They deplete the balance sheet.

I warned about the deterioration of balance sheets in my Dec. 12, 2005 column. Since then the volume has been turned up, and many high-quality bonds are becoming junky overnight.

The rating agencies have been dropping ratings with scary speed. In the first part of this decade they typically waited after an announcement about increased debt to see what the company did with the borrowed money. Now they are lowering the ratings first and looking later.

For example, Affiliated Computer Services, which runs outsourced data processing departments, in late January announced a buyback of up to 55.5 million shares. It will borrow as much as $3.5 billion to finance the deal. Moody’s downgraded Affiliated Computer’s bonds from Baa1 to a junk bond rating of Ba2. Standard & Poor’s reaction was equally punitive; it lowered the rating from bbb+ to the junk grade of BB+. Standard & Poor’s placed the company on review for further downgrade.

Corporate spending on stock buybacks has exploded. Standard & Poor’s estimates that the companies in the S&P 500 spent $315 billion on share buybacks last year, versus $197 billion in 2004.

Rating agencies are unhappy, too, about the rising level of acquisitions. Look at what happened when Supervalu unveiled its purchase of another supermarket chain, Albertsons, for $3.8 billion in cash, $2.5 billion in stock and the assumption of $6.1 billion in Albertsons debt. Both rating agencies quickly put Supervalu bonds on negative credit watch, saying they may downgrade them to junk. Supervalu bonds swooned. The 7.5s due May 2012, which had traded at 107.7 cents on the dollar for a 6% noncallable yield to maturity, tanked to 103.25 for a 6.85% yield.

That was a quick $44.50 loss for every $1,000 of face value. Supervalu management anticipates immediate benefits and synergies from the Albertsons takeover, but it won’t help make up for those bond losses.

First Data, which processes credit card, bank and retail payments, has sought to please the stock market by a spinoff of Western Union, now a money transfer business. Details won’t be disclosed until after first-quarter earnings, but the ratings agencies are being preemptive. Western Union provided 45% to 50% of First Data’s operating income (earnings before interest, taxes, depreciation and amortization), and that contribution will be missed in servicing the debt. First Data’s bonds, rated A1 by Moody’s and A+ by Standard & Poor’s, swiftly got downgraded to A2 by Moody’s and put on negative credit watch by Standard & Poor’s. If the company recommences its share buyback program, the rating might well decline to bbb.

Wendy’s International, whose hamburger chain is limping along on flat-to-down same-store sales, thinks it can please Moody’s and S&P by divesting good properties. It recently received a $63 million pretax gain from real estate sales. The chain also announced a plan for a 15% to 18% stock offering in its thriving Tim Hortons Canadian doughnut operation for $600 million and a tax-free spinoff of the remainder. The cash is nice, but Tim Hortons provides 60% of Wendy’s operating income. These seemingly clever strategic initiatives have landed Wendy’s bonds on a negative credit watch.

You get the picture. Credit quality risk is accelerating, which means it’s time for bond buyers to get conservative. Read carefully every bit of news about the high-grade companies you already own. Get out if management makes the wrong move.

For your new money I recommend short-term Treasurys. With today’s flat yield curve, six-month Treasury bills and two-year notes offer as much yield as ten-year Treasurys, with less risk. Nor is the modest yield gain offered by most corporate bonds worth the risk.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.

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