Will the Fed Kill the Stock Buyback Boom?

Corporate America is bullish.

Not necessarily on the economy. But it’s bullish on its own stocks.

federal-reserveStock buybacks have soared to record levels in the last year. For example, in February companies announced more than $104 billion in planned buybacks. That number has doubled in the last year.

This isn’t a recent trend. Since 2009, the companies in the S&P 500 index have spent more than $2 trillion buying back stock.

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Never in history have corporations been so shareholder friendly. For most large companies, returning cash to shareholders is the status quo. Last year, S&P 500 companies spent 95% of their earnings on stock buybacks and dividends.

But the stock buyback boom could slow down later this year. That’s because Fed Chairwoman Janet Yellen is expected to raise interest rates before the end of 2015. While higher rates will benefit retirees with savings in the bank, the move will have a profound impact on stock buybacks and dividends.

Many companies are tapping the debt markets to fund their ever-expanding stock buyback programs and growing dividend payments.

Let’s examine Apple (NASDAQ: AAPL). Measured by market capitalization, it’s the largest company in the world. It also happens to be returning a record $200 billion of cash to shareholders through its stock buyback program and dividend payments.

Apple is an absolute cash machine. The company’s big profit margins have helped its cash stash grow to a robust $178 billion. To put that in perspective, Apple’s cash balance equals more than 10% of total cash held by U.S. non-financial companies.

But most of Apple’s cash is sitting outside of the U.S. That’s because Apple uses international tax loopholes to reduce its U.S. tax bill. The company is hesitant to repatriate its international tax, because doing so would result in lots of taxes.

So Apple’s solution is to borrow money. Earlier this month, Apple issued $7 billion of new bonds. That adds to the $40 billion of long-term debt on its balance sheet as of March 30. Interestingly, 90% of that debt has been taken on since 2012, when Apple initiated its stock buyback and dividend.

Right now, it’s extremely inexpensive for companies to borrow money. For example, it costs just 2%-3% for a high-quality company like Apple to issue new debt. Additionally, companies are able to write off expenses related to interest payments. That makes it incredibly attractive to borrow money.

And it’s all a direct result of the Federal Reserve’s 0% interest rate policy. With interest rates so low, borrowing money is a no-brainer.

In the boardrooms of corporate America, the decision to buy back shares and increase dividends is easy. These shareholder friendly initiatives reduce the number of shares of stock, increase earnings per share and attract income investors.

But if the Fed starts raising interest rates in a meaningful way, the cost to borrow money will jump as well. When that happens, companies may be less inclined to borrow money to fund shareholder initiatives.

Fewer stock buybacks could be an important factor that slows down this bull market. A small rate hike won’t make much of a difference, but if the federal funds rate were to rise to 2%, the cost of borrowing would increase dramatically.

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