Triple A rated technology giant Microsoft's offer to purchase Activision Blizzard has rekindled concern about acquisition risks for credit investors, as companies take advantage of large cash piles and easy financing conditions to splurge on growth targets rather than maintaining iron-clad balance sheets.
Microsoft said on Tuesday it would acquire the video game publisher for US$68.7bn, with the proposed deal following on the heels of last year's US$19.7bn pending offer to buy cloud company Nuance.
Filings show that Microsoft is sitting on a cash hoard of US$130.6bn, so even if it bought Activision and Nuance entirely in cash, it would still have around US$42bn of reserves on hand. But the cheap financing available in the corporate bond market has fueled speculation that it will use debt to fund the Activision acquisition.
Certainly the price action in Microsoft's bonds suggests investors are expecting the deals to involve bond market financing. Its 2.921% 2052 senior notes widened to Treasuries plus 83bp on Thursday (the day after news of the deal broke) from around plus 77bp on January 14, according to MarketAxess.
"Higher-rated companies have much more freedom to expand the balance sheet if needed, and a potential downgrade within investment-grade does not impact borrowing costs materially," wrote Yuri Seliger, a credit strategist at Bank of America. "These actual and potential M&A deals highlight the one-sided credit risk for industrial issuers rated Single A or better."
Those considerations have depleted the ranks of companies carrying gold-plated credit ratings. Aside from Microsoft, Johnson & Johnson is the only other corporation to retain a Triple A rating from all three major credit agencies, a far cry from the 1980s when such ratings were a dime a dozen.
Free money
With the after-tax cost of debt running so low, even companies that can carry out all-cash transactions find it hard not to turn to the debt markets to pay for acquisitions – especially after taking into account the rate of US inflation, which ran at an annualised rate of 7% in December.
“You can borrow at negative real yields to buy assets that are going to be productive over time, so it’s a pretty good opportunity,” said a banker. "The money's free. That's a pretty powerful incentive."
And if doing so results in a ratings downgrade, the increase in interest costs that follows is minimal: the gap between spreads for the average Triple A and Double A bond was 6bp on Tuesday, according to ICE BofA data.
“If I’m a CFO, I would do that all day long. What is the real risk of being downgraded from Triple A to Double A? There’s not much of a penalty," said Adam Coons, a portfolio manager at Winthrop Capital Management.
A more prosaic reason for Microsoft to finance a chunk of the Activision deal via debt is to prevent the equity portion of its capital structure from becoming bloated. Such motivations have turned cash-rich Apple into a recurring borrower in the investment-grade bond market.
“If [Microsoft] tapped the bond market it would be just to really even out their capital structure,” said Coons. “You have to issue debt just to keep up with the growth of the equity.”
Though the Activision purchase underlined worries Microsoft may be becoming more open to acquisitions, any issuance that arose from the deal would offer investors a welcome opportunity to stock up on the tech company's bonds, prized by investors for their defensive characteristics.
Cash cow
Microsoft has not been in the primary market since the Trump administration passed tax reform legislation allowing companies to repatriate overseas profits at a lower tax rate than before.
Yet even if Microsoft does end up financing some or all of the Activision acquisition through debt, the size of Microsoft's cash hoard should more than make up for the increase in leverage, diminishing the risk of ratings agencies snatching away the Triple A rating. After the acquisition announcement, S&P said it would keep its stable outlook on Microsoft's rating unchanged.
"While US$68bn sounds like a lot of money, in the context of Microsoft’s cashflow and cash on hand, it’s a very manageable amount," said Nathaniel Liddle, senior research analyst for Columbia Threadneedle.
He noted that when Microsoft purchased professional services network LinkedIn for US$26.2bn in 2016, its gross leverage rose to around 2.5 times but it was still able to keep its Triple A credit rating. Leverage has since dropped to 0.6 times. After the Activision acquisition, gross leverage is unlikely to push above 1.5 times, said Liddle.
