Conventional wisdom in markets is little more than fashion, but fashionable views and modes of corporate behaviour tend to become more and more entrenched the longer a bull or bear phase of the market runs. Friday’s Wall Street Journal ran pieces challenging two of the most widely-held assumptions on Wall Street – that the ratings placed on corporate and municipal bonds by the two big rating agencies are of biblical validity, and that the share buy-back programme is a Good Thing. The purpose of the ratings applied by the Big Two, Moody’s and Standard & Poors, who between them evaluated over 92% of the issues made this year, is to provide an impartial assessment of the likelihood that the borrower will default. They get paid well by the companies who need a rating on their paper in order to be able to sell it at all: issuers pay $1,000 to $50,000 depending on the complexity of the issue. And the difference between a triple-A rating and a single-A these days is a coupon of 7.35% on the former, 8.35% on the latter. The subject has become much more important with the enormous growth over the past four years of junk bond financing of acquisitions and buy-outs. Junk bond ratings start at double-B-plus at S&P, Ba1 at Moody’s, the lowest investment grades being triple-B-minus and Baa3 respectively. But the Journal reports research suggesting that investors may be too highly rewarded for buying junk bonds, and that a broad portfolio of the latter may well outperform one made up of investment grade bonds while the risk of default of any of the former is less than might be imagined – junk bonds have an average annual default rate of 1.67%, but investment grade corporate bonds default at an average annual 0.14%. The agencies would stress that their ratings are only a guide. What of share buy-backs? The argu-ment for these is that the company buying in some of its shares is paying back surplus profit to its shareholders because with fewer shares out, the earnings per share will rise. And in the past, companies have bought in their shares only where they believed they were markedly undervalued. But of late, companies have been buying their shares on ratios way above the market average – and that at a time when the bull market must be near its peak. Among the most enthusiastic buyers-in has been IBM – over the past couple of years but also in the late 1970s, just before it embarked on the biggest investment programme in its history – and had to borrow heavily to finance it. Did it really make sense to spend cash on its own shares rather than on the new plants it was shortly to build? Unless specifically to meet the needs of an employee share incentive scheme, a share buy-back always looks a defeatist move by management – has it really nothing better in the business to spend its money on than its own shares? And in the context of the cash-voracious computer industry, it looks just plain crazy.
