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A post-mortem on repatriation

admin | September 14, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

More than $300 billion in offshore corporate cash and fixed income securities came home to the US in the wake of last December’s tax reform. The 15 largest holders then almost immediately sold $66 billion in securities largely to help buy back equity. The estimated $700 billion in remaining corporate holdings still hang over the market. Since corporate cash ultimately should go toward investing in the business, buying back equity or paying dividends, pricing in the markets where corporations traffic looks biased to soften. In the cross-hairs: the Treasury and commercial paper markets and, by extension, LIBOR.

Last December’s tax reform imposed a 1-time tax on existing offshore corporate cash portfolios regardless of whether the corporation brought the cash home or not. Corporations have eight years to pay. Prior US policy had taxed offshore profits whenever a company brought them home, incentive for US corporations to stockpile an estimated $1 trillion in offshore earnings. With no incentive to hold cash offshore any more, companies in the first quarter of this year brought more than $300 billion home – after bringing well under $50 billion home quarterly from most of the last 15 years (Exhibit 1).

Exhibit 1: US corporations in 1Q18 repatriated $300B ($Billions)

Source: Federal Reserve, US Corporations’ Repatriation of Offshore Profits, FEDS Notes Sep 4, 2018, using the BEA balance of payments data.

The largest holders of corporate cash portfolios apparently went right to work selling. Total securities among the largest 15 cash portfolios dropped in the first quarter by nearly 3% of total corporate assets or $66 billion. It is likely that the sale proceeds helped fund a noticeable spike in equity share buybacks (Exhibit 2).

Exhibit 2: The Top 15 corporate cash portfolios sold securities to buy shares

    Ratio: net securities purchases to assets        Ratio: share buybacks to assets

Source: Federal Reserve, US Corporations’ Repatriation of Offshore Profits, FEDS Notes, Sep 4, 2018, using Compustat, Bloomberg.

With an estimated $700 billion in corporate cash still remaining and no clear tax incentive to hang onto the positions, the markets where corporations invest should be nervous. Among the most liquid financial assets held by corporations, savings accounts, money market funds, mutual funds, commercial paper and Treasury and repo agreements make up 94% (Exhibit 3). The money market and mutual funds are likely to have substantial holdings in commercial paper and Treasury bills, so the effective exposure of those markets to corporate asset allocation is likely much larger than the direct holdings. Based on the widening of front-end credit spreads in the first quarter, a disproportionate part of the corporate selling in the first quarter apparently came in commercial paper. Since commercial paper is one of the few active markets that provide a reference for pricing bank credit, LIBOR widened, too.

Exhibit 3: Corporations hold sizable direct and, through funds, indirect positions in Treasury securities and commercial paper.

Note: Financial assets of non-financial corporations. Source: Federal Reserve, Financial Accounts of the United States, June 7, 2018, APS.

Commercial paper and other short markets in corporate debt should remain under pressure. Strong but uncertain growth, rising but relatively low interest rates and strong equity markets keep giving corporations incentives to buy back equity. More corporate cash should flow from investment portfolios into equity buybacks, and commercial paper, LIBOR and the markets that reference them should see the effects.

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The view in rates

Rates inched higher and the curve flattened by a couple of basis points in the most recent week. The 10-year Treasury closed the week touching the ceiling of 3.00%. The coming week provides little high impact market data, and we enter the pre-FOMC blackout period for Fed speakers. Look for near-term market drivers from potential tariff-related headline risk and storm damage reports. Weight could possibly be taken off the long end as whatever remaining tax-driven pension fund buying expires over the September 15 corporate tax date. Expect calm and steady trading with rates trickling higher and the curve flatter, before the pace picks up again around the FOMC meeting and into quarter-end.

The view in spreads

Spreads have broadly rolled sideways lately, with investment grade corporate, high yield and emerging markets debt slightly tighter in September and agency MBS slightly wider. Strong US growth might make a bullish case for spreads for now, but longer trends run in the other direction. The Fed is draining liquidity, the risk profile of investment grade credit keeps rising with corporate leverage and even corporate cash repatriation runs to softer spreads. Anecdotal evidence suggests that investors are starting to reallocate away from investment grade credit and into other things. Although agency MBS is likely to do better than credit, the gravitational pull on spreads generally is wider.

 The view in credit

A good economy has kept fundamental credit in bounds, but the risk from any softening keeps rising. Leverage has kept rising in investment grade debt, higher LIBOR has kept the pressure on interest rate coverage in leveraged loans and a stronger US dollar has softened prospects for emerging markets. Household balance sheets look strong by comparison. The fundamentals would argue for reallocation from corporate into consumer debt.