Ultra-low interest rates and record-low bond yields have created an environment that’s friendly to financial engineering, but as the U.S. Federal Reserve begins to hike rates and bond yields edge higher, some are questioning whether this practice will end soon. It is an important question though because financial engineering has been driving a lot of stocks, and if it comes to an end, even more volatility will ensue.
However, Barclays analysts say there’s no reason to worry about this—at least not yet anyway, so you can still have your financial engineering (for now)!
How financial engineering boosts stock prices
Apple, Microsoft and numerous other companies have been focusing on buying back shares for the purpose of returning capital to shareholders. In order to do this though, they’ve taken on debt rather than repatriating some of their overseas cash, which would come with hefty corporate taxes. Bond yields are extraordinarily low right now, so Barclays analyst Jonathan Glionna said it makes perfect sense for companies to issue as much debt as they can to fund share repurchases.
Shareholders have been rewarding financial engineering techniques such as this by sending the stock prices of companies that do them higher. According to Glionna, S&P 500 companies have spent over $2.5 trillion repurchasing their shares over the last five years. Over this same time, the index has climbed 70%, indicating that investors actively seek companies that repurchase their shares and reward them for doing so.
The reverse is also true, as he noted that during the financial crisis, quarterly share repurchases plunged 86%. As a result, he thinks a broad, dramatic slowdown in buybacks is one of the contributing factors in when market corrections turn to widespread selloffs.
Financing conditions starting to reverse
The Barclays analyst also notes that credit spreads have skyrocketed, causing some investors to believe that the financial engineering era is drawing to a close. Companies depend heavily on the credit market to fund their share repurchases, so it’s understandable that the shift in the financing environment is a cause of concern pertaining to financial engineering methods such as these.
He does note that financing conditions are now “more constrained” but adds that currently the investment grade market is still open. After all, buybacks that are funded by debt can only continue “if the credit market cooperates, although he also said that this isn’t the case for high-yield-rated companies any longer.
It’s the investment grade market that matters
S&P 500 companies in particular are more shielded from changes in the financial environment because of their investment grades. According to Glionna, the investment grade market’s issuance has continued to work even though the credit spread is widening. Further, January’s investment grade supply climbed 53% year over year, and he found that volume “remained brisk” last month.
“While new issue concessions have increased, the investment grade bond market remains open,” he added. “This implies that the era of financial engineering can continue, for now.”
Still a slight risk to financial engineering
Of course there is still a risk that financial engineering activities will slow dramatically if the credit markets tighten further. Glionna doesn’t believe there will be a recession in the U.S. soon, so he doesn’t think the current economic conditions have justified the stock market selloff. He adds that volatility in the financial markets could potentially validate stock price declines.
“One example of this is the financing markets. If volatility is high enough financing markets can close, imperiling shareholder friendly activities such as buybacks. So far this has not happened, but it is an ongoing risk,” he concluded.