Swapping Equity for Debt

When I was working out at the gym a few weeks ago, TJ Rodgers was on the Mad Money show on CNBC (I recall this being Friday January 25, but I cannot find video of this show on the Internet).

For those who haven’t seen the show, the host, Jim Cramer, affects a loud and bombastic personality. He seems to have an aggressive and sometimes emotional approach to picking stocks. I would not invest based on his show, but many seem to find it good entertainment to watch.

At any rate, there was a fascinating (to this monetary scientist) exchange between Jim Cramer and TJ Rodgers. Dr. Rogers said that his company, Cypress Semiconductor was borrowing money to buy its own shares. I recall he said that they had been doing this over the past year and still had some more money in the budget. What jolted me like a thunderclap, was Dr. Rogers statement that the company had never before had debt.

Let that sink in. A company which has not used debt historically, and which does not have a productive use for debt now, is borrowing money in an attempt to increase its share price. The other reason it is borrowing is to continue to pay a per-share dividend of $0.44 without the earnings to support it.

What they are doing is exchanging equity for debt. The rate of interest has been pushed so low that this seems like a good deal (or at least a good bet). After all, the monthly payment is quite affordable! What could go wrong, other than the liquidity risk that the debt cannot be rolled at some point? Dr. Rodgers assured Jim Cramer that if necessary, they would sell shares to pay off the debt. If they end up unable to borrow, then their share price will plunge. Selling shares then to pay off debt would dilute shareholders, if it were even possible to raise enough money that way.

A second thing can go wrong. The rate of interest can fall further, and it will. When this happens, the net present value of Cypress’ liability rises.

A third thing can wrong—and it already has. Cypress announced a share buyback in October 2010. I can’t tell what average price they paid per share but it appears the program went for one year. $18 seems a reasonable estimate from looking at their chart. They announced another program in Sep 2011. Their share price has fallen 44%, from $17.89, in the last 12 months. The only thing worse than rising liabilities is to use the money to fund falling assets with leverage.

While individual investors may think twice about buying shares with heavy use of margin, it looks different to the corporate CFO. The CFO will compare the yield on the bond he sells with the yield on the shares he buys. If the bond yield is significantly lower, the trade makes sense. I don’t know what Cypress paid for the money, but as I write this their dividend yield is 4.4%. I assume they paid significantly less than that.

To the extent he thinks about interest rates, he may think that they surely cannot go much lower. And, they may even rise significantly, in which case he can buy back his bonds from the market at a cheaper price.

If only the CEO and CFO understood that interest rates are falling and that falling rates destroy the capital of borrowers. If only they realized that they are consuming their capital, borrowing money to give shareholders dividends and a higher share price. If only we had a gold standard.

The principle virtue of the gold standard is to stabilize the rate of interest.