US debt markets still solid despite equity ructions

Via Moody’s:

Net Stock Buybacks and Net Borrowing Have Yet to Alarm

Recent outsized advances by equity prices probably owe something to either actual or anticipated buybacks of common stock. Both the relative steadiness of corporate credit quality and ample amounts of corporate cash now improve the outlook for equity buybacks.

In the Financial Accounts of the United States, the Federal Reserve supplies an estimate of net equity buybacks, where the estimate applies to net buybacks of both common and preferred equity. Because of an often heavy use of preferred stock by financial companies, net buybacks of nonfinancial-corporate equity are the preferred measure when analyzing the behavior of net equity buybacks over time. For example, the $55 billion of total net equity buybacks for the year-ended June 2018 consisted of $485 billion of net stock buybacks by U.S. nonfinancial companies and $281 billion of net equity issuance by U.S. financial institutions.

Net equity buybacks reduce the equity capital buffer protecting creditors. Thus, actual and anticipated increases in net stock buybacks can increase default risk and widen credit spreads. Moreover, the damage done to corporate credit quality by net stock buybacks will be amplified if equity buybacks are funded with increased debt.

The moving yearlong ratio of nonfinancial-corporate net stock buybacks to nonfinancial-corporate cash offers insight regarding the financial risks stemming from net stock buybacks. The lower net equity buybacks are relative to cash, the less downward pressure will equity buybacks put on corporate credit quality.

The moving yearlong sum of net nonfinancial-corporate buybacks is derived from Table F103 of the Financial Accounts of the United States, while nonfinancial-corporate cash is derived from Table L103 of the same publication. The definition of cash employed in this exercise excludes nonfinancial-corporate holdings of equity and mutual funds that are included in the Federal Reserve’s broad version of liquid financial assets.

Latest Ratio of Net Stock Buybacks to Cash Does Not Warn of Bear Market

For the year-ended June 2018, the $485 billion of net buybacks of nonfinancial-corporate equity approximated 22% of the group’s $2.186 trillion in cash. The latest ratio hardly differed from its 20% average of the 30-years-ended 2017.

In stark contrast, just prior to the outbreak of the Great Recession, December 2007’s yearlong ratio of net stock buybacks to cash was a record high 53%. In the final quarter of 2007, the market value of U.S. common stock set a cycle high.

Moreover, the yearlong ratio of net equity buybacks to cash set previous cycle highs at the 39% of June 1999 and the 45% of September 1989. Not long thereafter, the U.S. equity market topped off in March 2000 and June 1990, respectively. Thus far, the current recovery shows a September 2016 top of 31% for the yearlong ratio of net stock buybacks to cash.

Though the latest ratio of 22% is up from a December 2017 bottom of 14%, the ratio is low enough to suggest that many companies still have the financial resources with which to fund stock buybacks. In turn, it may be premature to declare the nearness of a long-lasting peak for the U.S. equity market.

Slide by Net Borrowing Offsets Climb by Net Stock Buybacks

Net equity buybacks offer only a limited measure of the change in a company’s capital structure. A more comprehensive estimate of the change in capital structure would add net borrowing to net equity buybacks. In terms of moving yearlong averages, though net stock buybacks rose from the $405 billion of the span-ended Q2-2017 to the $485 billion of the span-ended Q2-2018, nonfinancial-corporate net borrowing eased from $435 billion to $347 billion, respectively. Had net borrowing not subsided, current prospects for credit quality would have been worse than otherwise and corporate credit spreads would have been wider. Note that prior to the onset of the Great Recession, the calendar year averages rose from 2006’s $403 billion to 2007’s record-high $658 billion for net borrowing and from 2006’s $497 billion to 2007’s current zenith of $706 billion for net equity buybacks. For now, at least, corporate net borrowing and net stock buybacks fall considerably short of what preceded the financial crisis.

Ratios of Net Borrowing and Net Buybacks to GDP Fall Way Short of 2007’s Highs

Relative to nominal GDP, nonfinancial-corporate net borrowing has been subdued, while net equity buybacks have topped their long-term trend. More specifically, during the 12-months-ended June 2018, nonfinancial-corporate net borrowing approximated 1.7% of nominal GDP, which was under its longterm median ratio of 2.4%. At the same time, June 2018’s 2.4% yearlong ratio of nonfinancial-corporate net stock buybacks to GDP exceeded its long-term median of 1.6%. The yearlong ratio of net borrowing to GDP set its record high in December 1984 at 5.1% and established its sample low at the -2.2% of December 2009. (Negative net borrowing implies that nonfinancial corporations reduced outstanding indebtedness.) In addition, the yearlong ratio of net stock buybacks to GDP set its zenith at December 2007’s 4.9% and set multiple sample bottoms at the -0.6% of September 1983, December 1983, June 1992 and September 1992. (Negative net stock buybacks imply the issuance of common equity by nonfinancial companies exceeds the buyback, or retirement, of common equity.)

Latest Net Leverage Ratio Complements a Still Benign Default Outlook

The sum of net borrowing as a percent of GDP plus net stock buybacks as a percent of GDP – or the net leverage ratio — offers insight regarding the likely direction of corporate credit quality. However, some time may pass before an increase by net borrowing and net stock buybacks relative to GDP helps to trigger a disruptive ascent by the default rates. In fact, the high-yield default rate shows a coincident inverse correlation of -0.57 with the sum of net borrowing and net stock buybacks as a percent of GDP implying that the default rate declines as the net leverage ratio increases. Only by comparing the default rate with earlier net leverage ratios does the expected positive correlation emerge. For example, the default rate does not generate a positive correlation of at least 0.50 until the default rate is set against the net leverage ratio of seven quarters earlier. In fact, the default rate’s peak correlation is 0.59 with the net leverage ratio of nine quarters earlier.

For the year-ended June 2018, the net leverage ratio of 4.2% matched its long-term median of 4.2%, which is well under March 2016’s 6.4% high for the current business cycle upturn. The yearlong net leverage ratio set its record high at the 9.4% of December 2007 and had been as high as 6.5% at the end of 2006. Earlier peaks for the yearlong net leverage ratio were set at June 1999’s 6.6%, March 1989’s 6.8%, December 1986’s 6.8%, and December 1987’s 7.1%. Thus, the latest modest ratio of net borrowing and net stock buybacks to GDP complements the benign outlook for high-yield defaults. Nevertheless, history still warns of significantly wider corporate credit spreads that presage a prolonged and disruptive climb by the default rate.

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