Cash Flows may be drying up: Buyback Alarm

Backgroud: One of the most enduring justifications for the current credit boom has been the idea that corporations continue to sit on healthy cash hoards.

The thinking: Robust cash flows, ------> help hold down the risk of default and imbue bond investors with the confidence that even their riskier holdings will hold up, at least in the short term.

Issue: But the underlying assumption that companies remain awash in cash may be eroding, and without many investors realizing it.

• The most recent flow-of-funds data released by the Federal Reserve shows that free cash flow in the nonfinancial corporate sector plummeted late last year, according to Dominic Konstam, head of rates research at Credit Suisse. As credit spreads show signs of inching upward, a ramping up of corporate leverage at a time when cash is flowing to share buybacks could send bond spreads surging higher.

Free cash flow, calculated as internal funds less capital spending and buybacks, typically runs slightly negative and at most reaches about 2% of gross domestic product, according to Mr. Konstam.

• In the most recent flow of funds report, however, that figure plummeted to minus 5% of GDP, about as low as Mr. Konstam said he has ever seen it.
  "I think it's alarming, and I think a lot of people are unaware," Mr. Konstam said.

Cause: The major culprit, Mr. Konstam said, is share buybacks.

• As risk premiums, or spreads over Treasurys, for corporate bonds hover near historic lows, companies have been able to borrow money at unusually low-cost interest rates. Many companies have then used their cash borrowings to repurchase stock shares, boosting the value of remaining shares.
• With this surge in buybacks, Mr. Konstam said, earnings growth has not been able to keep pace."Weak cash flow historically is not sustainable," Mr. Konstam said. "Either earnings must go up or investment or buybacks down."
• In fact, corporate investment poses another major concern, according to Tom Higgins, chief economist at Payden & Rygel. Mr. Higgins noted that companies are increasingly turning their backs on capital investment at a time when profits are peaking.
  Given the general health of corporate credit, Mr. Konstam said that deteriorating cash flow is unlikely to produce sudden, catastrophic effects such as those seen when funding dried up in the subprime lending sector. Instead, he predicted a steady widening of spreads, one that he says has already begun.
  

Data: Treasury Prices Decline; Yield Rises to 4.761%
Treasury-bond prices ended lower Friday, with the yield curve flattening, as a Reuters/University of Michigan consumer-sentiment survey sparked a selloff in government bonds. The survey, indicating consumers' higher expectations for inflation,, was the last piece of data on the day, and for some bond traders canceled out an inflation-soothing producer-prices report of earlier in the day.