Wrath of Financial Engineering: It’s Now Eating into Earnings

Companies with investment-grade credit ratings – the cream-of-the-crop “high-grade” corporate borrowers – have gorged on borrowed money at super-low interest rates over the past few years, as monetary policies put investors into trance. And interest on that mountain of debt, which grew another 4% in the second quarter, is now eating their earnings like never before.

These companies – according to JPMorgan analysts cited by Bloomberg – have incurred $119 billion in interest expense over the 12 months through the second quarter. The most ever.

With impeccable timing: for S&P 500 companies, revenues have been in a recession all year, and the last thing companies need now is higher expenses.

Risks are piling up too: according to Bloomberg, companies’ ability pay these interest expenses, as measured by the interest coverage ratio, dropped to the lowest level since 2009.

Companies also have to refinance that debt when it comes due. If they can’t, they’ll end up going through what their beaten-down brethren in the energy and mining sectors are undergoing right now: reshuffling assets and debts, some of it in bankruptcy court.

But high-grade borrowers can always borrow – as long as they remain “high-grade.” And for years, they were on the gravy train riding toward ever lower interest rates: they could replace old higher-interest debt with new lower-interest debt. But now the bonanza is ending. Bloomberg:

As recently as 2012, companies were refinancing at interest rates that were 0.83 percentage point cheaper than the rates on the debt they were replacing, JPMorgan analysts said. That gap narrowed to 0.26 percentage point last year, even without a rise in interest rates, because the average coupon on newly issued debt increased.

And the benefits of refinancing at lower rates are dwindling further:

Companies saved a mere 0.21 percentage point in the second quarter on refinancings as investors demanded average yields of 3.12 percent to own high-grade corporate debt – about half a percentage point more than the post-crisis low in May 2013.

That was in the second quarter. Since then, conditions have worsened. Moody’s Aaa Corporate Bond Yield index, which tracks the highest-rated borrowers, was at 3.29% in early February. In July last year, it was even lower for a few moments. So refinancing old debt at these super-low interest rates was a deal. But last week, the index was over 4%. It currently sits at 3.93%. And the benefits of refinancing at ever lower yields are disappearing fast.

What’s left is a record amount of debt, generating a record amount of interest expense, even at these still very low yields.

“Increasingly alarming” is what Goldman’s credit strategists led by Lotfi Karoui called this deterioration of corporate balance sheets. And it will get worse as yields edge up and as corporate revenues and earnings sink deeper into the mire of the slowing global economy.

But these are the cream of the credit crop. At the other end of the spectrum – which the JPMorgan analysts (probably holding their nose) did not address – are the junk-rated masses of over-indebted corporate America. For deep-junk CCC-rated borrowers, replacing old debt with new debt has suddenly gotten to be much more expensive or even impossible, as yields have shot up from the low last June of around 8% to around 14% these days:


Yields have risen not because of the Fed’s policies – ZIRP is still in place – but because investors are coming out of their trance and are opening their eyes and are finally demanding higher returns to take on these risks. Even high-grade borrowers are feeling the long-dormant urge by investors to be once again compensated for risk, at least a tiny bit.

If the global economy slows down further and if revenues and earnings get dragged down with it, all of which are now part of the scenario, these highly leveraged balance sheets will further pressure already iffy earnings, and investors will get even colder feet, in a hail of credit down-grades, and demand even more compensation for taking on these risks.  It starts a vicious circle, even in high-grade debt.

Alas, much of the debt wasn’t invested in productive assets that would generate income and make it easier to service the debt. Instead, companies plowed this money into dizzying amounts of share repurchases designed to prop up the company’s stock and nothing else, and they plowed it into grandiose mergers and acquisitions, and into other worthy financial engineering projects.

Now the money is gone. The debt remains. And the interest has to be paid. It’s the hangover after a long party. And even Wall Street is starting to fret, according to Bloomberg:

The borrowing has gotten so aggressive that for the first time in about five years, equity fund managers who said they’d prefer companies use cash flow to improve their balance sheets outnumbered those who said they’d rather have it returned to shareholders, according to a survey by Bank of America Merrill Lynch.

But it’s still not sinking in. Companies are still announcing share buybacks with breath-taking amounts, even as revenues and earnings are stuck in a quagmire. They want to prop up their shares in one last desperate effort. In the past, this sort of financial engineering worked. Every year since 2007, companies that bought back their own shares aggressively saw their shares outperform the S&P 500 index.

But it isn’t working anymore. Bloomberg found that since May, shares of companies that have plowed the most into share buybacks have fallen even further than the S&P 500. Wal-Mart is a prime example. Turns out, once financial engineering fails, all bets are off. Read… The Chilling Thing Wal-Mart Said about Financial Engineering

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  25 comments for “Wrath of Financial Engineering: It’s Now Eating into Earnings

  1. CrazyCooter says:

    Which is why it is often said that “low interest rates destroy capital”. Money has to have a price, it is how the system allocates precious capital to the projects that have the best returns (e.g. productivity gains, efficiency gains, expansion of production, etc).

    We are quite simply burning the house down.



  2. Jungle Jim says:

    The real question is what will happen once the wave of defaults begins. We are awash in Credit Default Swap’s that are supposed to cover that situation. Of course the notional value of those swaps far exceeds all the money in existence, so paying off is out of the question. Ah, but what then ? Unquestionably, the derivatives will amplify the default problem, probably a lot.

    Warren Buffett once quipped “when the tide goes out, you’ll see who was swimming without a bathing suit”. That tide seems to be ebbing fast.

  3. Bruce Adlam says:

    Back in 2007/8 the fed opened up the printing press and lowered interest rates to free up liquidity .once they achieve that The responsible thing to do is bring it back to normal levels .instead the fed created massive distortions in the market place. Now it’s game set and match.
    The fed back in 2007 and now should be held responsible and jailed for negligence to the wider community. That will never happen. No wonder we don’t trust them nor should we

    • economicminor says:

      This whole thing started a long time ago. Probably in the mid 1990’s. By 2008 there was no going back.. There was no way to *normalize* the interest rates because there was already way to much debt to be serviced by actual value added productive enterprise.

      Actually it is Congress that should be jailed as they created this mess with their repeal of Glass Steagal and the creation of the Commodities Modernization Acts plus tax breaks and unfunded stupid wars. And while were are wishing, the perps at the big banks that followed the crowd to mega profits and incomes at the expense of their clients could also go.

      But wishing and hoping is a waste of time so I’ll just go back to preparing my garden for the winter and looking forward to spring.

  4. rich says:

    Apple has taken on over $55 billion in debt in order to pay for stock buybacks and dividends. Apple says it is doing so for tax reasons, but Forbes sees it a problematic. Hard to know for sure if all the cash that Apple says it has stashed in offshore accounts is really there.

    IBM has been borrowing heavily in order to pay for its stock buybacks and dividends. The company’s debt is now over $50 billion while its revenues have been falling

    (Bloomberg) “International Business Machines Corp.’s borrowing costs are rising even as those of its peers fall, underscoring concerns that the world’s largest seller of computer services is struggling to find its place in the cloud.”

    • Nick Kelly says:

      I think that’s about Apple’s profit for a quarter- if that long.
      There are companies to worry about not that one.
      IBM is a zombie by comparison.
      One thing that keeps it going- legacy software that has been patched by SA’s long since dead that everyone is terrified to touch. Government, as you might expect is a museum of old tech that still bills monthly.

      BTW- the whole Apple special dividend came about after Icahn bought some 1 % of the stock and of course wanted to get paid off.
      Too bad Cook couldn’t have channeled Steve Jobs, who wouldn’t have taken Icahn’s call.
      And yes the IRS was going to grab a big piece of it, if it was repatriated.
      But you’ve interested me to find out what Forbes is talking about.

    • Nick Kelly says:

      So I just entered ‘Forbes on Apple’s loan’ and got a piece written Feb. 2015 which was when this all went down.
      The piece I read was entirely about tax- Apple pays about 3 % overseas and if they repatriated the IRS would want 35 % less the 3 %.
      The writer’s point was to change US tax law not any misgivings about Apple’s financials.

  5. unit472 says:

    “Financial Engineering” is a strange term in that ‘engineering’ is about designing something to able to withstand the maximum operational stress it is likely to encounter. An aeronautical or civil engineer does not design a wing or a bridge based on the most favorable circumstances but the worst possible ones. OTOH these so called ‘financial engineers’ are all about using leverage to weaken a balance sheet.

    • hoop says:

      Financial engineering: How does this system works. Or how to move forward. I assume the banks own the secured loans. So step 1. Wipe out shareholders and unsecured bond/loan holders. Step 2. Convert the secured bonds/loans to share capital. Step 3. issue new secured debt and Step 4. start a new round of levering via unsecured debt. Rinse and repeat. It looks like it can stand the test of design to ’withstand the maximum operational stress it is likely to encounter’

      Off course at a certain moment a product/service become outdated because the technical changes, alternatives arrive and taste of the consumer for the product changes etc.

  6. merlin says:

    So, who are the ultimate losers? The investors, of course.

    See this related article from Fuelfix; it should have been titled “Fleecing the Sheeple” .


  7. rich caldwell says:

    Share buybacks meta-strategy = IBGYBG…

  8. hoop says:

    Are the bag holders in place ? Who owns the secured loan/bonds of these indebted companies ? Who owns the unsecured bonds/loans and shares in these companies ergo the back holders ?

    • Wolf Richter says:

      They’re in your bond mutual fund and your loan mutual fund and in your pension fund. They’re in ETFs. Hedge funds and PE firms own them. Bonds and loans are far bigger than stocks. They’re everywhere. They’re used as collateral. They’re in CLOs and CDOs. They’re in triple-A yen-denominated bonds (sold to Japanese retail investors) that are backed by currency-hedged dollar-CLOs that are backed by leveraged loans issued by junk-rated over-indebted US corporations….

      • hoop says:

        My question was one of the sarcastic type. I know already that they are sold off to the right people :)

        Must admit that I never heard of a ‘’Triple-A yen-denominated bonds that are backed by currency-hedged dollar-CLOs that are backed by leveraged loans issued by junk-rated over-indebted US corporations.

        :D :D

      • economicminor says:

        And that is the real problem isn’t it.

        When this toxic wasteland of debts erupts in a fiery plumb, most all of us are down wind in one way or another.

        What happens to the consumer society when most of the pension funds find out they have such huge losses? Think we have a lack luster retail environment now, just wait and watch.

        Stock buy backs were about top management greed. Keeping the value of their stock options up while they fleece the company. As long as they could walk away with billions, it didn’t seem to matter to them that they leave behind a hollow hulk of non productive debts.

        • John Doyle says:

          In the current financial world of fiat money Federal Governments can always step in to save pension funds from bad management practices. The Government itself should never borrow or save in it’s sovereign currency so only private funds are going to need bailing out, if a SHTF event occurs – which it will!

          That old expression “taxpayer dollars” is only used by persons ignorant of modern macroeconomics. Federal taxes are simply the cost recovery for excess spending by governments. No taxes would be used as bail outs so no taxpayers are involved. It would hardly matter how big the bail out was, as the government can never go bankrupt in its own currency.

      • DanR says:

        Could the “bagholder risk” be reduced by replacing ETFs with a basket of stocks, such as the 30 Dow stocks themselves, and by replacing bond mutual funds with actual 10 year notes, 5 year notes, 90 day T bills, etc.?

  9. Petunia says:

    My thoughts on the Apple and IBM buybacks were that they were borrowing here in the US and paying back the money overseas. It would be a way to repatriate the overseas cash without the tax burden or over site. I don’t really know if this is what they are doing but it looked that way to me. I know, I am tooooo cynical.

  10. ERG says:

    Anyone still think the Fed will raise rates this year?

    Next year?


    [the sound of crickets chirping]

  11. Tim says:

    Institutional fund managers have close relationships with brokerage and dealer units, and corporates have close relationships with commercial bank finance units. The Fed has not been controlling the ultra low yield corporates, it is the cozy relationship between the fund managers and the big commercial banks and corporates. They agree on the low rates, the fund investors foot the bill, and get stiffed. The managers and running agents get a real nice cut. (And the corporate looters get a huge cut too, with the bond funded stock buy backs, dividends, and pay for performance.) ‘The reach for yield’ is a bit of a myth, sell side spin, to cover the real determinant, the relationship between the fund managers and the big commercial banks/ bond running agents/ corporate financing units. Since the rates are largely dictated by those relationships, everyone else is out of luck, and has to go along with the charade. And the ratings agencies are in on it. Once the game proceeds far enough, the revenue streams have to shrink, debt servicing has to suffer, and the inevitable defaults, bankruptcies and foreclosures arrive. And the fund investors get stiffed again. When you hear ‘reach for yield’, don’t.

    “Income is transferred to debtors in inflation, assets are transferred to creditors in deflation.” That is the real name of the game, so don’t reach for yield.

    • Petunia says:

      The interest rate game is a farce. My credit cards go all the way up to 25%. They didn’t have a problem raising my rates.

      • Tim says:

        No low interest rates for me, either. Only the plutocrats get the low rates. The class system is the interest rate system, the interest rate ladder.

  12. Randy says:

    Oh Brother! Here we are, right at the edge of the cliff, just about to go over it, and people are still expecting that we’re going to somehow make it safely to the other side of the chasm? What folly is this? No amount of conjuring of more electronic bookkeeping entries out of thin air or printing up fiat paper currency is going to do anyone any good at all, it will just make things even WORSE than they are now, just as where we are now is far worse than we were at before!!
    Once you start down the path of using a fiat paper currency, it just gets worse and worse until it kills you.


  13. ERG says:

    Re: Interest rates. Now you know why we are about to go into an “official” recession as opposed to the same old one we’ve been experiencing since 2008/09. Their bag of tricks is empty so now even more extraordinary measures will be needed to save corporations and financial institutions. The solution to theft is always more theft.

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