Post by blueneck on May 9, 2007 5:23:13 GMT -6
Good Jubak artcile that explains why artificially low interest inflates the stock market.
How cheap debt overinflates stocks
Today's availability of easy money distorts calculations that are used to determine whether stocks are overvalued or undervalued and makes the markets hard to read.
Cheap money is fueling the buyout boom.
Cheap money is prompting companies to buy back billions of dollars' worth of their own shares.
Cheap money is fueling big increases in corporate dividend payouts.
Perhaps best of all -- for investors long on the market, anyway -- cheap money is keeping the current rally running, even as the U.S. economy runs out of steam, by convincing investors that stocks are undervalued even as they hit historic highs.
So how does cheap money work its magic?
Sallie Mae's dance with debt
Let's start with a recent deal, the $25 billion buyout of student-loan giant SLM Corp. (SLM, news, msgs), better known as Sallie Mae.
On April 16, private-equity investors J.C. Flowers and Friedman Fleischer & Lowe, along with Bank of America (BAC, news, msgs) and JPMorgan Chase (JPM, news, msgs), announced a $25 billion bid for Sallie Mae.
At $60 a share, the offer represented a 50% premium above the pre-buyout bid price of the shares. As you can imagine, shares of Sallie Mae rocketed toward the offer price -- though thanks to saber rattling by Washington politicians, the stock stalled short of $60. It seems some folks on Capitol Hill think having private investors control a company that makes government-guaranteed loans might be a bad idea. (Wherever do members of Congress get these notions?)
The deal also lighted a fire under the shares of other companies that provide student loans. Nelnet (NNI, news, msgs) shares climbed 15%, and shares of The Student Loan Corp. (STU, news, msgs) rose 5%.
It also goosed the prices of shares in the financial sector in general. Investors had thought that financial stocks, because regulators frown if they load on too much debt, were likely to be left out of the buyout boom. But if Sallie Mae can get a bid, why not other financials? In the days after the buyout news broke, shares of Countrywide Financial (CFC, news, msgs) rose 6%, and those of CIT Group (CIT, news, msgs) climbed 9%.
Debt, of course, is critical to the Sallie Mae deal. The four investors are putting up $8.8 billion in cash, but most of the deal will be financed with debt. As in any leveraged buyout, that debt, more than $16 billion of it, will be piled onto Sallie Mae's balance sheet.
All that debt will sink Sallie Mae's bond rating. Rating agencies Standard & Poor's, Moody's and Fitch have already said that they're likely to downgrade the company's credit rating from its current A in S&P's system. That's not the highest grade in S&P's system but clearly qualifies as investment grade. A downgrade to one of the speculative grades, say five steps down to double-B, would drive up the interest rate that Sallie Mae would have to offer investors to get them to buy its bonds.
An easy entry for the banks
But here's where the wonders of the current reign of King Cheap Money comes in. Because money is so cheap right now, the downgrade wouldn't cost the company very much. Right now, the coupon interest rate on Sallie Mae's debt is 6% to 6.4%. In the current market, a drop to a double-B credit rating would cost the company less than 2.1 percentage points. That would drive the coupon that Sallie Mae has to offer up from, say, 6.4% to 8.5%.
That's not chicken feed when you're talking about $16 billion in debt. Annually, it comes to an extra $340 million in interest that Sallie Mae will have to pay. But that bill is still, historically, cheap. The median increase in yield from such a downgrade over the past 20 years is more like 3.1 percentage points. That would add an additional $160 million a year to the interest bill at Sallie Mae.
The boom in leveraged buyouts is rallying the stock market, but it could spell trouble for bond investors -- especially those who own investment grade bonds. MSN Money's Jim Jubak explains how to check your portfolio to prevent big losses.
(Owners of Sallie Mae's current A-rated bonds aren't likely to think the downgrade is cheap. Bonds fall in price when they suffer a credit-rating downgrade, and the price of Sallie Mae's bonds took a 5% hit in the days after the deal was announced.)
Cheap money makes it possible to do this deal. The investors -- or, rather, Sallie Mae -- will pay just $1.3 billion a year on the $16 billion borrowed for the purchase. That modest interest plus the $2.2 billion in cash each is paying make this almost certainly a bargain for the banks in the deal: JPMorgan Chase and Bank of America get almost half-ownership of the biggest player in the extremely lucrative market for student loans, a market where they clearly want to gain market share.
Poof! An inflated P/E disappears
But let's look at the effects of the deal on the market as a whole. The buyout pushes up the price of Sallie Mae shares by 50% and of other financials by 5% or so. That's all reflected in the market indexes.
Any jump in price makes stocks seem more expensive, of course. But the way this and other deals work minimizes the jump in stock-market "expensiveness." Sallie Mae's price-earnings ratio jumped from 17 before the deal to 24 after it was announced.
But Sallie Mae, the stock (and the inflated P/E), will be no more when the deal is done. Same with the jump in risk represented by that $16 billion in debt and the $1.3 billion in annual interest payments. As soon as the deal is completed, the company will go private, and all these numbers will vanish. The increased P/E ratio for Sallie Mae shares will disappear from all calculations of stock-market valuation.
Buyout deals that take higher valuations out of the public market aren't the only way that cheap money is distorting calculations that are frequently used to determine whether stocks are overvalued or undervalued.
Overpaying the shareholder
Take the practice of using borrowed money to buy back shares. Bet you thought all those buybacks that companies are announcing were funded out of current cash flow. Think again. Even big players such as IBM Corp. (IBM, news, msgs) are piling on debt to repurchase their own shares.
Since 2003, IBM has purchased 203 million of its own shares at a total cost of $30.7 billion. That's a huge percentage -- about 52% -- of the company's total operating cash flow of $59.5 billion during the period. It looms even larger if you add in the $17 billion IBM spent during this period on capital expenditures, the $8.8 billion it spent acquiring businesses and the $5.3 billion it spent paying dividends to investors. All that -- added to the spending on buying its own shares -- comes to 104% of operating revenue.
Or look at it another way. In 2006, IBM used the equivalent of 67% of its total net income to buy back shares. In 2005, the percentage was 82%. In the two years before that, 64% and 42%, respectively.
If you add in dividends, 2006 payouts to investors came to 85% of total net income at IBM.
That's the level of payout ratio that sends up a red flag to investors, I've been taught, because it's clearly not sustainable over the long run. In fact, from its financial statements it looks like IBM is borrowing to keep up this level of payout while keeping its business running as usual. Cheap money makes that possible.
read more here
articles.moneycentral.msn.com/Investing/JubaksJournal/HowCheapDebtOverinflatesStocks.aspx
How cheap debt overinflates stocks
Today's availability of easy money distorts calculations that are used to determine whether stocks are overvalued or undervalued and makes the markets hard to read.
Cheap money is fueling the buyout boom.
Cheap money is prompting companies to buy back billions of dollars' worth of their own shares.
Cheap money is fueling big increases in corporate dividend payouts.
Perhaps best of all -- for investors long on the market, anyway -- cheap money is keeping the current rally running, even as the U.S. economy runs out of steam, by convincing investors that stocks are undervalued even as they hit historic highs.
So how does cheap money work its magic?
Sallie Mae's dance with debt
Let's start with a recent deal, the $25 billion buyout of student-loan giant SLM Corp. (SLM, news, msgs), better known as Sallie Mae.
On April 16, private-equity investors J.C. Flowers and Friedman Fleischer & Lowe, along with Bank of America (BAC, news, msgs) and JPMorgan Chase (JPM, news, msgs), announced a $25 billion bid for Sallie Mae.
At $60 a share, the offer represented a 50% premium above the pre-buyout bid price of the shares. As you can imagine, shares of Sallie Mae rocketed toward the offer price -- though thanks to saber rattling by Washington politicians, the stock stalled short of $60. It seems some folks on Capitol Hill think having private investors control a company that makes government-guaranteed loans might be a bad idea. (Wherever do members of Congress get these notions?)
The deal also lighted a fire under the shares of other companies that provide student loans. Nelnet (NNI, news, msgs) shares climbed 15%, and shares of The Student Loan Corp. (STU, news, msgs) rose 5%.
It also goosed the prices of shares in the financial sector in general. Investors had thought that financial stocks, because regulators frown if they load on too much debt, were likely to be left out of the buyout boom. But if Sallie Mae can get a bid, why not other financials? In the days after the buyout news broke, shares of Countrywide Financial (CFC, news, msgs) rose 6%, and those of CIT Group (CIT, news, msgs) climbed 9%.
Debt, of course, is critical to the Sallie Mae deal. The four investors are putting up $8.8 billion in cash, but most of the deal will be financed with debt. As in any leveraged buyout, that debt, more than $16 billion of it, will be piled onto Sallie Mae's balance sheet.
All that debt will sink Sallie Mae's bond rating. Rating agencies Standard & Poor's, Moody's and Fitch have already said that they're likely to downgrade the company's credit rating from its current A in S&P's system. That's not the highest grade in S&P's system but clearly qualifies as investment grade. A downgrade to one of the speculative grades, say five steps down to double-B, would drive up the interest rate that Sallie Mae would have to offer investors to get them to buy its bonds.
An easy entry for the banks
But here's where the wonders of the current reign of King Cheap Money comes in. Because money is so cheap right now, the downgrade wouldn't cost the company very much. Right now, the coupon interest rate on Sallie Mae's debt is 6% to 6.4%. In the current market, a drop to a double-B credit rating would cost the company less than 2.1 percentage points. That would drive the coupon that Sallie Mae has to offer up from, say, 6.4% to 8.5%.
That's not chicken feed when you're talking about $16 billion in debt. Annually, it comes to an extra $340 million in interest that Sallie Mae will have to pay. But that bill is still, historically, cheap. The median increase in yield from such a downgrade over the past 20 years is more like 3.1 percentage points. That would add an additional $160 million a year to the interest bill at Sallie Mae.
The boom in leveraged buyouts is rallying the stock market, but it could spell trouble for bond investors -- especially those who own investment grade bonds. MSN Money's Jim Jubak explains how to check your portfolio to prevent big losses.
(Owners of Sallie Mae's current A-rated bonds aren't likely to think the downgrade is cheap. Bonds fall in price when they suffer a credit-rating downgrade, and the price of Sallie Mae's bonds took a 5% hit in the days after the deal was announced.)
Cheap money makes it possible to do this deal. The investors -- or, rather, Sallie Mae -- will pay just $1.3 billion a year on the $16 billion borrowed for the purchase. That modest interest plus the $2.2 billion in cash each is paying make this almost certainly a bargain for the banks in the deal: JPMorgan Chase and Bank of America get almost half-ownership of the biggest player in the extremely lucrative market for student loans, a market where they clearly want to gain market share.
Poof! An inflated P/E disappears
But let's look at the effects of the deal on the market as a whole. The buyout pushes up the price of Sallie Mae shares by 50% and of other financials by 5% or so. That's all reflected in the market indexes.
Any jump in price makes stocks seem more expensive, of course. But the way this and other deals work minimizes the jump in stock-market "expensiveness." Sallie Mae's price-earnings ratio jumped from 17 before the deal to 24 after it was announced.
But Sallie Mae, the stock (and the inflated P/E), will be no more when the deal is done. Same with the jump in risk represented by that $16 billion in debt and the $1.3 billion in annual interest payments. As soon as the deal is completed, the company will go private, and all these numbers will vanish. The increased P/E ratio for Sallie Mae shares will disappear from all calculations of stock-market valuation.
Buyout deals that take higher valuations out of the public market aren't the only way that cheap money is distorting calculations that are frequently used to determine whether stocks are overvalued or undervalued.
Overpaying the shareholder
Take the practice of using borrowed money to buy back shares. Bet you thought all those buybacks that companies are announcing were funded out of current cash flow. Think again. Even big players such as IBM Corp. (IBM, news, msgs) are piling on debt to repurchase their own shares.
Since 2003, IBM has purchased 203 million of its own shares at a total cost of $30.7 billion. That's a huge percentage -- about 52% -- of the company's total operating cash flow of $59.5 billion during the period. It looms even larger if you add in the $17 billion IBM spent during this period on capital expenditures, the $8.8 billion it spent acquiring businesses and the $5.3 billion it spent paying dividends to investors. All that -- added to the spending on buying its own shares -- comes to 104% of operating revenue.
Or look at it another way. In 2006, IBM used the equivalent of 67% of its total net income to buy back shares. In 2005, the percentage was 82%. In the two years before that, 64% and 42%, respectively.
If you add in dividends, 2006 payouts to investors came to 85% of total net income at IBM.
That's the level of payout ratio that sends up a red flag to investors, I've been taught, because it's clearly not sustainable over the long run. In fact, from its financial statements it looks like IBM is borrowing to keep up this level of payout while keeping its business running as usual. Cheap money makes that possible.
read more here
articles.moneycentral.msn.com/Investing/JubaksJournal/HowCheapDebtOverinflatesStocks.aspx