HEARD ON THE STREET
Updated November 9, 2012, 9:18 a.m. ET
Cracks in Fortress Balance Sheets
By RICHARD BARLEY
Don't worry, company balance sheets are strong. Corporate bond investors have been repeating this mantra since the start of the financial crisis. It has helped many fund managers deliver stellar returns from buying bonds of nonfinancial companies. The only problem is that it is starting not to be true.
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Cost-cutting and debt reduction after the collapse of Lehman Brothers put company finances on an improving path. But now they are eroding. In the U.S., the median debt burden for a sample of 275 investment-grade companies has risen 32% since the third quarter of 2010, pushing leverage—or the ratio of debt to earnings—up to 1.9 times from a low of around 1.5 times in 2011, Citigroup C -0.19%notes. Shareholder-friendly share buybacks and dividends are increasing. In Europe, a similar picture emerges: in the year to the end of June, 28% of investment-grade companies and 22% of high-yield borrowers saw both earnings fall and debt rise—a potentially toxic mix, Morgan Stanley MS +0.54% notes.
The reversal is starting to show up in credit ratings—which despite the hit to credibility caused by the financial crisis, still matter for investors with ratings-driven mandates. In the third-quarter, U.S. industrial downgrades by Standard & Poor's leapt ahead of upgrades, with 93 companies cut and 36 raised. And in western Europe, the rot has spread beyond countries hit by the sovereign debt crisis.
Since the start of July, there have been 25 downgrades and just six upgrades for industrial companies from Germany, the U.K., France and the Netherlands, S&P data show. Downgrades to "junk" have hit steel producer ArcelorMittal, MT.AE +1.09% car maker Peugeot UG.FR -0.74% and phone maker Nokia NOK1V.HE +1.06%.
True, companies have built up strong liquidity buffers, a source of reassurance for bondholders. But while aggregate corporate cash holdings are impressively high—around $1.7 trillion in the U.S. in March 2012, equivalent to 11% of gross domestic product, according to Fitch—they may be skewed by large companies such as Apple AAPL +1.73% that aren't debt issuers. Bondholders might hope boards will continue to protect them on the grounds that bank lending remains unreliable. In Europe, companies like France Telecom FTE.FR +0.13% and KPN
The worry is that the flood of cash into the corporate bond market, which has driven yields in the U.S. and Europe to record lows, has been particularly focused on "safe-haven" nonfinancial company debt. That creates the risk that some bonds are now overpriced for a cycle of rising leverage. Investors who cling to the siren song of strong balance sheets could yet end up on the rocks.
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