The business case for slough­ing off AAA credit rat­ings

▶▶The in crowd is kiss­ing per­fect bond rat­ings good­bye ▶▶“If ev­ery­one else is bor­row­ing, you tend to bor­row, too”

Bloomberg Businessweek (Asia) - - CONTENTS - Peter Coy, with Srid­har Natara­jan and Michelle F. Davis The bot­tom line For many com­pa­nies, us­ing their money to ex­pand or to make share­hold­ers happy is worth let­ting their AAA S&P rat­ing drop.

Sta­tus sym­bols don’t last for­ever. The orig­i­nal Queen Mary no longer sails, Cadil­lac stopped mak­ing the DeVille in 2005, and hav­ing an S&P credit rat­ing of AAA isn’t what it used to be. Exxon­Mo­bil CEO Rex Tiller­son told CNBC in March that he hoped to main­tain a triple-A rat­ing “be­cause it’s im­por­tant to us rep­u­ta­tion­ally.” But when push came to shove, rais­ing the div­i­dend and buy­ing back shares were higher pri­or­i­ties than keep­ing debt

low enough to pre­serve that pris­tine credit rep­u­ta­tion. Last month, S&P Global Rat­ings knocked the com­pany down to AA+. That leaves only two non­fi­nan­cial cor­po­rate AAA’s in the U.S., Mi­crosoft and John­son & John­son,

down from 60 in 1980.

A triple-A rat­ing is a to­ken of bal­ance-sheet per­fec­tion. In­vestors ac­cept lower rates on the bonds of AAArated com­pa­nies be­cause their for­mi­da­ble fi­nan­cial resources mean there’s al­most no risk they’ll miss a pay­ment. S&P judges a triple-A bor­rower to have “ex­tremely strong ca­pac­ity to meet its fi­nan­cial com­mit­ments,” while a dou­ble-A bor­rower has only “very strong ca­pac­ity.” The top rat­ing at ri­val Moody’s In­vestors Ser­vice is Aaa.

In cer­tain cir­cles, a full set of A’s

con­veys pres­tige. “It’s that whole AAA aura, like a halo ef­fect,” says Diane Vazza, a man­ag­ing di­rec­tor in global fixed-in­come re­search at S&P. But cor­po­rate chiefs have to find the best way to de­ploy resources, and hav­ing a triple-A rat­ing can re­flect an ex­cess of pru­dence.

Fi­nance the­ory says a com­pany should bal­ance tax sav­ings against the risk of bank­ruptcy. In­ter­est pay­ments on debt are tax-de­ductible, so it’s ad­van­ta­geous to bor­row—es­pe­cially now, when the Fed­eral Re­serve’s easy­money poli­cies have made bor­row­ing cheap even for com­pa­nies with a less-than-per­fect bal­ance sheet. As the chart to the right shows, AAA-rated non­fi­nan­cial cor­po­rate debt yielded only 0.13 per­cent­age points less than AA-rated is­sues in April, ac­cord­ing to data col­lected by Bank of Amer­ica Mer­rill Lynch. Cash-rich Ap­ple could earn a triple A eas­ily, but the AA+ it has to­day re­flects its choice to bor­row to re­ward share­hold­ers.

The mass de­ser­tion of the AAA re­flects a larger truth about cor­po­rate fi­nance: Com­pany managers are strongly in­flu­enced by what their peers are do­ing, says Aswath Damodaran, a fi­nance pro­fes­sor at NYU’s Stern School of Busi­ness. “If ev­ery­one else is bor­row­ing, you tend to bor­row, too,” he says.

Of course, debt is a prob­lem if the burden gets too heavy and the risk of de­fault rises. Yields in­vestors de­mand

sky­rocket when a com­pany falls into the CCC’s. The sen­si­ble spot is some­where be­tween the ex­tremes.

One in­di­ca­tion that fads af­fect fi­nanc­ing de­ci­sions is that lever­age ra­tios swing wildly. For com­pa­nies in the S&P Com­pos­ite 1500 in­dex, they’ve jumped lately. The av­er­age ra­tio of net debt to earn­ings be­fore in­ter­est, taxes, de­pre­ci­a­tion, and amor­ti­za­tion rose from 0.7 in 2006 to 1.9 in 2015. “The idea of boost­ing re­turns in a de­lib­er­ate debt-funded way has be­come more ac­cept­able,” says An­drzej Sk­iba, a money man­ager at BlueBay As­set Man­age­ment.

Bor­row­ing to pay for div­i­dends and buy­backs will one day go out of style just as quickly as it’s come into style, says NYU Stern’s Damodaran. “You need the equiv­a­lent of a cor­po­rate Prozac to calm these guys down, be­cause they’re es­sen­tially bipo­lar,” he adds.

J&J de­nies it’s be­ing ir­ra­tionally con­ser­va­tive by cling­ing to all three of its A’s. “We’re very proud of the fact that we’re AAA-rated, but we would not let that alone be a de­ter­mi­nant in whether or not we al­lo­cated cap­i­tal to in­crease share­holder value,” Do­minic Caruso, the com­pany’s chief fi­nan­cial of­fi­cer, told an­a­lysts last year. J&J an­nounced a $10 bil­lion share-re­pur­chase pro­gram in 2015 and this April raised its div­i­dend for the 54th consecutiv­e year.

Mi­crosoft, which has more than $100 bil­lion in cash and short-term se­cu­ri­ties, is so stuck on its AAA that it doesn’t even get ques­tions from

an­a­lysts about it. The com­pany, which de­clined to com­ment, has steadily raised its div­i­dend and bought back shares—a demon­stra­tion that it doesn’t need to lose its AAA to re­ward share­hold­ers. Like­wise, an Exxon­Mo­bil spokesman says that de­spite the S&P

down­grade, “nothing has changed in terms of the com­pany’s fi­nan­cial phi­los­o­phy or pru­dent man­age­ment of its bal­ance sheet.” Moody’s still gives the com­pany its top rat­ing.

Credit qual­ity doesn’t mat­ter only to in­vestors. Com­pa­nies that loaded up on debt in the early to mid-2000s were more likely than oth­ers to fire work­ers once the 2007-09 re­ces­sion hit, ac­cord­ing to a Na­tional Bureau of Eco­nomic Re­search work­ing pa­per is­sued last year. Weak bal­ance sheets were “in­stru­men­tal in the prop­a­ga­tion of shocks” dur­ing the cri­sis, Xavier Giroud of MIT’s Sloan School of Man­age­ment and Hol­ger Mueller of the Stern School of Busi­ness wrote in the re­port. De­ci­sions about debt may be idio­syn­cratic, but they’re def­i­nitely con­se­quen­tial.

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