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The debt bubble legacy of economists Modigliani and Miller

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Half a century ago, two starlets of economics argued that whether companies funded themselves with debt or equity was irrelevant. One legacy of that insight is becoming clearer in the wreckage of corporate failures mounting in the wake of the pandemic.

Franco Modigliani and Merton Miller both later won the Nobel Prize in economics, partly thanks to their groundbreaking work on what became known as the “M & M theorem”. Until then most companies had assumed that too much debt would affect the value of the firm, so their paper was a counterintuitive bombshell.

Their initial findings only held in a world without “frictions” — such as taxes, imperfect information and inefficient markets. But a later revisitation that incorporated the tax-deductibility enjoyed by interest payments showed that the value of an indebted company is actually higher than that of an unleveraged one. It eventually helped lay the intellectual groundwork for a dramatic erosion of corporate creditworthiness

If the mix of funding is in practice irrelevant to the overall cost, why not leverage up and increase returns to shareholders that own the business, and, indirectly but no less importantly, corporate executives? Indeed, given that debt enjoys tax breaks in most countries, isn’t it almost irresponsible not to take advantage? When interest rates began to fall globally in the 1980s, many companies did just that. That executive compensation is largely tied to earnings per share was an additional incentive for companies to leverage up.

Later on, other economists would give the corporate borrowing binge more academic legitimacy by arguing that debt was a potent tool to ensure corporate discipline and therefore increase economic dynamism. This gave rise to the idea of “efficient” balance sheets layered with debt.

The result can be seen in the evolving distribution of corporate credit ratings. Four decades ago, Standard & Poor’s had given 65 companies around the world a spotless triple A rating, equal to almost 6 per cent of its total ratings. Another 679 companies enjoyed ratings in the A range. Today there are only five — five! — companies with triple A ratings, out of nearly 5,000 companies. And under 14 per cent of all rated companies are in the A range.

Column chart of Number of S&P non-financial credit ratings, by grade showing Global creditworthiness has atrophied since the 1990s

Once again, we can see the cost all around us. For sure, the Covid-19 pandemic was an extraordinary shock that could have threatened the solvency of even the sturdiest company. But the fact that so many companies around the world are far from sturdy is a major reason why governments and central banks had to go to eye-popping lengths to moderate a tidal wave of corporate bankruptcies. 

Those efforts have largely been successful. Yet the cost has been gargantuan. After 2008, there was a reckoning with banks and how they fund themselves. After 2020, there should be a similar overhaul for companies. The aim can obviously not be to immunise every company completely from every crisis. But a shift from efficient to resilient balance sheets would be a long-term boon to the health of the financial system and the global economy. 

Ideally, this should happen in response to the signals already being sent by markets: The shares of companies with stronger balance sheets have this year massively outperformed those with weaker ones, according to Goldman Sachs data. But if this proves a fleeting phenomenon — as is likely — then more countries should start taking a hard look at the tax advantages enjoyed by debt. Such a draconian move can only be done carefully, over a long period of time. But everyone would benefit from a world where companies once again aspire to be more creditworthy.

robin.wigglesworth@ft.com

Twitter: @robinwigg



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European stocks stabilise ahead of US inflation data

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European equities stabilised on Wednesday after a US central banker soothed concerns about inflation and an eventual tightening of monetary policy that had driven global stock markets lower in the previous session.

The Stoxx 600 index gained 0.4 per cent and the UK’s FTSE 100 rose 0.6 per cent. Asian bourses mostly dropped, with Japan’s Nikkei 225 and South Korea’s Kospi 200 each losing more than 1.5 per cent for the second consecutive session.

The yield on the 10-year US Treasury bond, which has dropped in price this year as traders anticipated higher inflation that erodes the returns from the fixed interest securities, added 0.01 percentage points to 1.613 per cent.

Global markets had ended Tuesday in the red as concerns mounted that US inflation data released later on Wednesday could pressure the Federal Reserve to start reducing its $120bn of monthly bond purchases that have boosted asset prices throughout the Covid-19 pandemic.

Analysts expect headline consumer prices in the US to have risen 3.6 per cent in April over the same month last year, which would be the biggest increase since 2011. Core CPI is expected to advance 2.3 per cent. Data on Tuesday also showed Chinese factory gate prices rose at their strongest level in three years last month.

Late on Tuesday, however, Fed governor Lael Brainard stepped in to urge a “patient” approach that looks through price rises as economies emerge from lockdown restrictions.

The world’s most powerful central bank has regularly repeated that it will wait for several months or more of persistent inflation before withdrawing its monetary support programmes, which have been followed by most other major global rate setters since last March. Investors are increasingly speculating about when the Fed will step on the brake pedal.

“Markets are intensely focused on inflation because if it really does accelerate into this time near year, that will force central banks into removing accommodation,” said David Stubbs, global head of market strategy at JPMorgan Private Bank.

Stubbs added that investors should look more closely at the month-by-month inflation figure instead of the comparison with April last year, which was “distorted” by pandemic effects such as the price of international oil benchmark Brent crude falling briefly below zero. Brent on Wednesday gained 0.5 per cent to $69.06 a barrel.

“If you get two or three back-to-back inflation reports that are very high and above expectations” that would show “we are later into the economic recovery cycle,” said Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management.

He added that the pandemic had sped up deflationary forces that would moderate cost pressures over time, such as the growth of online shopping that economists believe constrains retailers’ abilities to raise prices. Widespread working from home would also encourage more parents and carers into full-time work, he said, “increasing the labour supply” and keeping a lid on wage growth.

In currency markets on Wednesday, sterling was flat against the dollar, purchasing $1.141. The euro was also steady at $1.214. The dollar index, which measures the greenback against a group of trading partners’ currencies, dipped 0.1 per cent to stay around its lowest since late February.



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Potash/grains: prices out of sync with fundamentals

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The rising tide of commodity prices is lifting the ricketiest of boats. High prices for fertiliser mean that heavily indebted potash producer K+S was able to report an unusually strong first quarter on Tuesday. Some €60m has been added to the German group’s full year ebitda expectations to reach €600m. Its share price has gone back above pre-pandemic levels.

Demand for agricultural commodities has pushed prices for corn and soyabeans from decade lows to near decade highs in less than a year. Chinese grain consumption is at a record as the country rebuilds its pork herd. Meanwhile, the slowest Brazilian soyabean harvest in a decade, according to S&P Global, has led to supply disruptions. Fertiliser prices have risen sharply as a result.

But commodity traders have positioned themselves for the rally to continue for some time to come. Record speculative positions in agricultural commodities appear out of sync even with a bullish supply and demand outlook. US commodity traders have not held so much corn since at least 1994. There are $48bn worth of net speculative long positions in agricultural commodities, according to Saxo Bank.

Agricultural suppliers may continue to benefit in the short term but fundamentals for fertiliser producers suggest high product prices cannot last long. The debt overhang at K+S, almost eight times forward ebitda, has swelled in recent years after hefty capacity additions in 2017. Meanwhile, utilisation rates for potash producers are expected to fall towards 75 per cent over the next five years as new supply arrives, partly from Russia. 

Yet K+S’s debt swollen enterprise value is still nine times the most bullish analyst’s ebitda estimate, and 12 times consensus, this year. Both are a substantial premium to its North American rivals Mosaic and Nutrien, and OCI of the Netherlands, even after their own share prices have rallied.

Any further price rises in agricultural commodities will depend on the success of harvests being planted in the US and Europe. Beyond restocking there is little that supports sustained demand.

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Amazon sets records in $18.5bn bond issue

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Amazon set a record in the corporate bond market on Monday, getting closer to the level of interest paid by the US government than any US company has previously managed in a fundraising. 

The ecommerce group raised $18.5bn of debt across bonds of eight different maturities, ranging from two to 40 years, according to people familiar with the deal. On its $1bn two-year bond, it paid just 0.1 percentage points more than the yield on equivalent US Treasury debt, a record according to data from Refinitiv.

The additional yield above Treasuries paid by companies, or spread, is an indication of investors’ perception of the risk of lending to a company versus the supposedly risk-free rate on US government debt.

Amazon, one of the pandemic’s runaway winners, last week posted its second consecutive quarter of $100bn-plus revenue and said its net income tripled in the first quarter from the same period a year ago, to $8.1bn.

The company had $33.8bn in cash and cash equivalents on hand at the end of March, according to a recent filing, a high for the period.

“They don’t need the cash but money is cheap,” said Monica Erickson, head of the investment-grade corporate team at DoubleLine Capital in Los Angeles.

Spreads have fallen dramatically since the Federal Reserve stepped in to shore up the corporate bond market in the face of a severe sell-off caused by the pandemic, and now average levels below those from before coronavirus struck.

That means it is a very attractive time for companies to borrow cash from investors, even if they do not have an urgent need to.

Amazon also set a record for the lowest spread on a 20-year corporate bond, 0.7 percentage points, breaking through Alphabet’s borrowing cost record from last year, according to Refinitiv data. It also matched the 0.2 percentage point spread first paid by Apple for a three-year bond in 2013 and fell just shy of the 0.47 percentage points paid by Procter & Gamble for a 10-year bond last year.

Investor orders for Amazon’s fundraising fell just short of $50bn, according to the people, in a sign of the rampant demand from investors for US corporate debt, even as rising interest rates have eroded the value of higher-quality fixed-rate bonds.

Highly rated US corporate bonds still offer interest rates above much of the rest of the world.

Amazon’s two-year bond also carried a sustainability label that has become increasingly attractive to investors. The company said the money would be used to fund projects in five areas, including renewable energy, clean transport and sustainable housing. 

It listed a number of other potential uses for the rest of the debt including buying back stock, acquisitions and capital expenditure. 

In a recent investor call, Brian Olsavsky, chief financial officer, said the company would be “investing heavily” in the “middle mile” of delivery, which includes air cargo and road haulage, on top of expanding its “last mile” network of vans and home delivery drivers.



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