Bondholders fret about leveraged buyouts (LBOs) late in the credit cycle. But this time around, with new federal lending rules slowing LBO activity, shareholder activism is stealing the spotlight—and the cash flows. The threat to bond portfolios is just as serious.
Activist investors, who buy stakes in public companies and then push for changes that will lift their share prices, aren’t new. And as our colleagues, Ashish Shah and Gershon Distenfeld, noted in a recent post, their tactics are usually more common during the late stages of a credit cycle.
But lately, calls for companies to carry out shareholder-friendly policies such as stock buybacks have been more frequent—and more aggressive. Shareholder activism at industrial companies in North America has increased steadily since 2010 and hit a record in 2014
In fact, activists these days don’t even need to own a large stake in a company to effect change, since the growth in passively managed investment strategies mean there are fewer big shareholders to stand up for company management.. General Motors, for instance, recently agreed to a $5 billion share buyback program to avoid a proxy war with a group of activist shareholders who owned only about 2% of the company.
The Threat to Credit Quality
Why is all this so worrisome for bond investors? Simply put: activists’ policy proposals are designed to enhance equity returns, often at the expense of a company’s overall credit quality. For instance, companies often finance share buybacks or dividend increases—two common activist investor demands—by taking on new debt.
In the past, boards tended to view share buybacks as an opportunistic tactic to be used when management thought the stock price was unjustifiably low. In such cases, repurchasing stock was judged likely to offer a better return than would other uses of capital, such as new product development or investment in new production.
But steady activist pressure today is prompting more companies to carry out buybacks on a regular schedule, regardless of valuation. This is unsettling because using excess cash to buy back shares limits a company’s ability to improve its credit quality by paying down debt. Lower cash balances also leave companies with smaller rainy day funds that they can tap when times get tough.
Know Your Risk—and What You’re Being Paid for It
Fortunately, there are things debtholders can do to protect themselves. First and foremost, they need to commit to an active approach of their own. By that, we mean they must be highly selective when deciding what to buy—and how much they should pay for perceived safety.
This is critical today because many of the cash-rich, low-debt companies that bond investors consider “safe” and will accept a low coupon to own are also the prime targets of activist investors—think Apple, Microsoft or PepsiCo, all of which have found themselves in activists’ crosshairs.
We think it’s fair to ask whether investors in highly rated “safe” securities are being adequately compensated for the risk they’re taking. Paying handsomely for high ratings can be tricky because public ratings are not reliable leading indicators of downside risk. This is partly because the ratings agencies often don’t address the risk of activism until after companies announce some sort of activist-inspired event, such as an authorization to buy back stock.
But make no mistake: prices react quickly when companies reveal plans to pursue shareholder-friendly policies, especially if those policies increase the chances of a ratings downgrade.
The “safe” securities also tend to be sizable components of corporate bond indexes, so when they sell off, the broader index suffers, too. That’s problematic for passive strategies that simply track the index. In our view, investors can avoid that by embracing actively-managed portfolios that allow investors to overweight or underweight individual bonds.
This means investors have to be forward looking. Rather than outsourcing their credit analysis to the ratings agencies, they should be independently examining the potential short- and intermediate-term credit risks a bond may face due to strategic shifts in corporate financial policy.
In today’s environment, investors may want to seek out lower-rated bonds with yields high enough to compensate for their downside risk while underweighting some “safe” names. Investors might also consider investing in bonds from companies that have already come under activist pressure and repriced accordingly.
Getting a Global Edge
Bond investors may also want to consider going global. The rise in shareholder activism is mostly a US phenomenon because regulation there favors shareholders over corporate management. In Europe and other regions, structural constraints such as insider ownership by families and governments, cross-shareholdings and lack of market liquidity have limited activist activity. An investment manager with a global footprint and global expertise stands a better chance at insulating a fixed-income portfolio against these US-led risks.
The surge in investor activism isn’t likely to die down soon. But while corporate boards may dread activist shareholders, corporate bond investors don’t have to. Thorough credit analysis and a hands-on investment approach should help them manage the risk—and sleep better at night.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.