When it comes to investing, debt is often a scary word. Investors are right to be wary of companies that keep a lot of debt on the balance sheet. In some ways, debt is like fire. It has the power to take an entire company down when used carelessly. But, put differently, debt can also be a very valuable tool for companies to improve their capital structure.
While it's understandable for investors to instinctively avoid companies with a lot of debt on the books, it's helpful to understand the motivation first before reacting impulsively. Recently, Microsoft Corporation (MSFT -1.27%) made news when it announced a huge debt issuance. But before investors rush for the exits, let's dig deeper to analyze how a debt offering may actually be beneficial to shareholders.
Microsoft takes advantage of cheap debt
Investors have likely heard that interest rates are still very low. Indeed, the yield on the 10-Year U.S. Treasury Bond recently touched 1.8%, which is nearly below the rate of inflation. This has created a major opportunity for companies with strong credit ratings to leverage their healthy balance sheets. By issuing debt at low enough rates, companies can create value for shareholders by using the proceeds from the bond offering to buy back stock.
This is why Microsoft announced that it would conduct a significant debt sale in a recent regulatory filing. While the exact number had not been identified, Reuters reported that the initial total was $7 billion. Microsoft received $26 billion in orders, signifying huge demand. This demand prompted Microsoft to increase the offering to $10.75 billion, according to a subsequent Bloomberg report.
As previously mentioned, some investors might get scared at the prospect of a company loading up on debt like this. But Microsoft is a special case. The company is one of only a few, including health care giant Johnson & Johnson and energy giant ExxonMobil, to hold a triple-A credit rating from Standard & Poor's. Their fortress balance sheets allow companies on this prestigious list to raise debt extremely cheaply.
Moody's rated Microsoft's debt offering at Aaa (prime) levels. The five-year, 10-year, and 30-year tranches are expected to carry rates at just 0.55%, 0.95%, and 1.4%-1.45% above comparable Treasuries, respectively.
Why Microsoft's debt sale makes sense
At first glance, it might seem like Microsoft is jeopardizing its pristine credit rating and rock-solid balance sheet by offering so much debt. But Microsoft has more than enough cushion to support the offering. At the end of last quarter, the company's long-term debt to equity ratio was a very slim 19%, so taking on additional long-term debt is not overly concerning.
Plus, Microsoft holds $90 billion in cash and short-term marketable securities, as well as an additional $12 billion in long-term investments on its books. The cash is piling up, yet Microsoft has a hard time using it, since a significant portion of its cash is held overseas. In order for Microsoft to actually use its own cash, it would have to repatriate it and pay a steep tax on it.
Raising cheap debt to fund its various corporate financial goals is a savvy way to put its cash to work while avoiding a big tax bill, and since interest rates are still low, Microsoft won't have to pay much for the privilege. With the proceeds, it's likely Microsoft will finance its large share buyback plan, based on company releases. Microsoft is currently in the midst of a massive $40 billion share buyback authorization. Along with last quarter's earnings, Microsoft management said it would complete the ongoing buyback authorization by the end of next year.
Issuing debt to finance these buybacks is a shrewd move, because it will ultimately be accretive to shareholders. Microsoft can issue cheap debt to retire its own stock, which currently pays a 3% dividend yield. Moreover, it's very likely that the cash sitting on Microsoft's balance sheet is doing very little to benefit shareholders. Since interest rates are so low, Microsoft probably is earning close to nothing on all that cash. This is why Microsoft's plan to raise debt to buy back its own shares is a very smart way of using low interest rates to its benefit.
