Corporate debt is coming home to roost in some style

Published on Friday 23 May 2008 21:13

THE markets have enjoyed a strong rally and are demonstrating a resilience that is very reassuring during a financial crisis that shows no real signs of coming to an end any time soon.

The next leg of the credit crunch, which has already had several laps of contagion, will be its affect on corporate debt. In the “go-go” years of the bull market of 2003 to 2007, companies were encouraged – and practically forced – to borrow up to the eyeballs all in the name of having an “efficient capital structure” – in effect having little capital and trading on cheap borrowed money. Rather than fund business through equity, many large companies borrowed cash and used it to pay dividends or buy back shares in the market. Going into hock was seen as the smart way to do business. This is all very well when money is cheap and plentiful – but woe betide the heavily-borrowed company when the rivers of money dry up.

We all know what happened next. Happily companies do not tend to borrow in the short term and their debt is held over the medium term. Nevertheless, at some point debt needs to be renewed and depending on the timeline of a company’s borrowings, tranches of debt need to be rolled over periodically.

However, right now is not a good time to renew any kind of debt. With the credit crunch in full swing, borrowers are not exactly flavour of the month and rates and terms, when they are available, are harsh. This means that if a company is going to find it impossible or prohibitive to borrow the money it needs it has to fall back on its shareholders and go cap in hand to them for more cash by issuing more shares in a rights issue. So the cycle turns and companies that borrowed money to buy back shares have to sell shares via a rights issue to pay back debt.

So rights issues are suddenly popping up all over the place and while the rush is mainly in the financial sector that created the credit problem in the first place, rights issues will quickly break out across the whole market as companies find themselves up against their own version of the “credit crunch”.

Some companies will fail but most will get by with a rights issue. This sounds a bit dire but in the long run it will give the shareholders in good companies an opportunity to buy cheap stock, which in the long term will make a nice return.

Meanwhile, the rickety companies that are loaded up with debt are best avoided, because those that have trouble will be in dire straits and forced to have “emergency rights issues”. That, while potentially lucrative, will test the stomach for risk of even the most bullish investors.

The credit crunch is not over and for the brave it will continue to provide long-term opportunities for profit.

&#149 Clem Chambers is chief executive of stocks and shares website ADVFN.