Takeover deals highlight bets on equities outperforming bonds
Hedge funds betting on the £32bn AbbVie bid for London-listed pharmaceutical company Shire, which wrapped up on Friday, tracked the US drugmaker’s private jet to and fro across the Atlantic to measure the progress of the talks.
American politicians are now paying close attention to transatlantic takeovers too, although their focus is on the tax revenues the US is losing as AbbVie becomes the largest company to shift its tax base from the US to Britain.
Investors should be focusing on how the deal is financed. AbbVie is borrowing £13.5bn from JPMorgan to help supply the cash it is offering, planning to repay the bridge loan later by issuing bonds.
In doing so, AbbVie is joining what is becoming the biggest corporate bet worldwide: that equities will outperform bonds.
Bond issuance has soared on both sides of the Atlantic as companies race to satisfy investor demand for a return above depressed government bond yields. In the eurozone corporate bonds yield an average of just 1.5 per cent, the lowest to date, according to the Barclays benchmark index, while in the US they are higher but not far above last year’s record lows.
If companies were investing this money in new factories and expanding output, this would be a sign they expect a bright future. Sadly, it is not the case. Compared to profits, investment remains depressed. In aggregate companies are borrowing money in order to buy shares, both their own and those of other companies.
The logic of this change in the capital structure is obvious for AbbVie. Its bridge finance costs it base rate plus zero to 0.5 per cent – a maximum of 1 per cent. If Shire cannot earn 1 per cent of the deal cost, it has no business being in business.
A broader justification applies for other companies: if profit as a percentage of the share price (the earnings yield, a measure of how much accrues to shareholders) is higher than the bond yield – and, crucially, expected to stay higher – it makes financial sense to issue bonds and buy shares. If a company does not do so itself, it can expect an acquirer to make the same calculation and launch a bid.
This equity-for-debt swap has been under way since 2010, with buybacks and debt issuance booming (although the near-perfect match between the two in the US since the late 1990s has broken down, with debt issuance soaring above buybacks in the past 18 months, BlackRock points out).
The economy may be miserable in the US, but takeovers are at boomtime levels. If this year’s trend continues, there will be $1.9tn of deals in the US in 2014, passing the $1.6tn peaks of 1999 and 2007. The world total would reach $3.9tn, trailing only 2006 and 2007, Dealogic data show.
Selling bonds looks like a no-brainer at these yields. Even central bankers, who were trying to encourage markets in the hope some of the gains would trickle into the real economy, have begun warning about froth in junk bonds and leveraged loans. For equity investors it should ring alarm bells too, as it is a modern version of the flawed “Fed model”. This approach, mentioned by the Federal Reserve in 1997, compares bond yields and the earnings yield, the inverse of the PE ratio.
The idea is that investors have a choice between bonds and shares, and the two yields measure what shareholders or bondholders can expect to make.
It is a good predictor of corporate financing. When shares were outrageously expensive in the dotcom bubble, finance directors naturally chose to sell them, racing to float, and financing deals by issuing equity. When the model showed bonds overpriced relative to equity in 2006 and 2007, companies sold debt to fund buybacks and takeovers.
Today it suggests debt is cheaper relative to equity even than during the credit bubble, so it should be no surprise to see buybacks and debt-funded acquisitions taking off.
Yet, the Fed model is deeply flawed. Theoretically, it makes no sense to compare fixed nominal bond yields to variable profits, which are broadly linked to inflation. Practically it has been a poor indicator, too. It worked from 1982 to the early 2000s, shortly after it was identified.
But investors who stuck with the modern version, comparing the forecast earnings yield to corporate bond yields, saw the strongest-ever buy signal in July 2008. After losing horribly in the crash, hardy souls still using the model received the strongest sell signal in five years in May 2009 – just as a raging bull market began.
Yet, if companies keep using the model to arbitrage bonds and equities, it matters. Companies have been the biggest buyers of US shares for years, supporting the market. If they gear up further to buy shares, they can levitate prices for a while, even as the long-term profit outlook is hurt by low investment. As in 2006-7, this is likely to prove temporary.