Amid Gloom, Balance Sheets Shine

Indeed, with massive cash on their balance sheets, fears of shrinking GDP should be tempered by some faith that corporations can take up the slack if consumers fall off the map.

Borrow This

Just like so many homeowners, companies took advantage of historically low interest rates earlier this decade to refinance their debts -- swapping higher interest rates and near-term maturities for low, longer-dated debts. Companies also took advantage of the low rates to lock in cash and credit facilities they expected to tap down the road (as in now). But companies became conservative about spending and hoarded much of their borrowings, as hard-learned lessons of overspending in the telecom and tech build-out of the late 1990s remained fresh.

Corporations have increasingly opened their wallets in recent years, thanks to the dividend tax cuts and pressure from activist shareholders.

In the first half of 2006, corporate America bought back about $200 billion in stock and paid out $108 billion in dividends, The Wall Street Journal reported last week in an inflammatory story entitled "Corporate Debt Begins to Worry Bond Investors."

Bondholders will always gripe when companies do shareholder-friendly activities. But the notion that the increase in stock buybacks and/or dividends threatens creditworthiness is premature. Thus far, there have been only 32 shareholder payment-related credit ratings downgrades this year, compared with the total 216 credit rating downgrades, according to Moody's.

Even if bondholder complaints are misplaced (or misreported), buybacks have yet to prove much of a boost to stock performance, writes Henry McVey, chief U.S. investment strategist at Morgan Stanley. Many companies doing buybacks are companies without much to invest in growth-wise, he writes, noting buybacks are less successful than they seem when you account for hedging and fees.

"Capital management in isolation is rarely a strategy for significant stock-price success," writes McVey. "Improving business fundamentals must also be in evidence."

Fundamentals are not crumbling, however, and any credit crunch is far off. Banks are still open for lending and access to capital in the public debt markets is strong. Easy lending standards, buoyed by a derivatives market that helps banks lay off risk, may not be healthy in the long run. But it is certainly extending the credit cycle well into the economic cycle.

Default rates are low at 1.7%, and ratings actions show credit quality is not deteriorating regardless of expectations for an economic slowdown. The ratio of upgrades to downgrades in the second quarter improved, as did the number of "positive outlooks," and the number of ratings under review for an upgrade, according to Moody's.

Merrill Lynch's distress ratio currently measures 2.8%. The distress ratio measures the number of bonds in the high-yield universe that trade with spreads over 1000 basis points to comparable Treasury bonds. Many bond investors use the ratio as a predictor of Moody's global default rate eight months down the road; the current reading forecasts a 2.4% global default rate by February 2007.

So as earnings filter in, the bond market seems to be saying the dark mood in the stock market is overshadowing some fundamental strength.