OK, I actually just invented this term myself, but I think it very accurately captures what’s currently going on in the bond and equity markets around the world. For a few years now, private equity funds have taken advantage of low bond yields and high equity earnings yields by issuing lots of debt very cheaply and taking companies private. Finance directors of companies still publicly listed have finally woken up to the threat posed by private equity, and are now increasing leverage voluntarily.
Expedia, the online travel company, has done precisely this, announcing that it is taking advantage of cheap debt to leverage up in an effort to enhance earnings. The company proposed that it would buy back a whopping $3.5bn of its equity, which is about 40% of its outstanding shares. Great news for equity holders – Expedia’s share price is up about 20% so far this month – but leveraging up is the last thing that bond holders want, and the spread on Expedia’s bonds maturing in 2018 shot up from 90 basis points to 210 basis points (a 10% drop in the bonds’ price) after S&P downgraded the bonds to high yield status.
Expedia is a slightly unusual case, in that leveraging up is normally what you’d expect from a company that has a high equity earnings yield (ie a low Price/Earnings ratio). At the beginning of June, though, Expedia’s leading P/E ratio was 21, implying a relatively low equity earnings yield of 4.7%. At this level, the need to leverage up is less apparent, and bond and equity markets alike were taken aback by Expedia’s announcement. Clearly, Expedia’s management behaviour suggests that the market is grossly underestimating the company’s future earnings growth.
A company where leveraging up has more obvious benefits is Home Depot, the giant US DIY firm. I first wrote about the possibility of Home Depot becoming a target for private equity in December last year and currently own Home Depot equity in the M&G Optimal Income Fund. The view was that Home Depot was under-leveraged and was a prime target for an LBO, albeit the company was (and still is) beyond the reach of private equity funds because of its $80bn market cap. Half a year later, and management has clearly bowed to shareholder pressure to enhance earnings. Home Depot today announced that it is seeking to buy back 30% of its outstanding equity, in a deal that will be partly funded by issuing $12bn of bonds. Again, great news for equity holders, and Home Depot’s equity is up 7% today. Bad news for bond holders though – Fitch ratings agency downgraded Home Depot’s bonds from A+ to A-, while both Moody’s and S&P have said they may downgrade the company’s credit rating.
I expect many more ‘LBIs’ and LBOs over the next 12 months, and continue to believe that the yield premium available on a number of corporate bonds is insufficient for the risk taken on.