Buybacks just got more expensive

Companies have enjoyed ten easy years of financial engineering. With interest rates at zero and interest payments tax-deductible, the playbook was simple. Borrow cheaply for the long term and buy back shares, and earnings per share would rise steadily without the bother of capital spending. That era formally ended on 16 August, when the Inflation Reduction Act became law with a one per cent excise tax on share buybacks from 2023. Add a government bond curve that has repriced sharply higher, and the hurdle for buying back stock has risen for good.

One per cent looks small. Corporate lobbyists have already brushed it off as a minor cost that can be folded into quarterly dividend planning. That misses how the levy combines with the collapse of debt-funded buybacks. Repurchases were never driven by tax rules alone. They depended on the gap between a company's earnings yield and its after-tax cost of borrowing.

Forty years of buybacks

The habit is younger than it looks. Until 1982, when the Securities and Exchange Commission adopted Rule 10b-18, a company buying its own shares risked accusations of manipulating the price; the rule offered a safe harbour, and repurchases grew from a curiosity into the main way American companies return cash. The 2017 tax reform, which cut the federal corporate rate from 35 per cent to 21 per cent and eased the repatriation of profits held abroad, set off another surge, and S&P 500 companies bought back a record amount of stock in 2021.

The record also shows that boards time repurchases badly. Companies bought back stock in record amounts in 2007, close to the market's peak, and cut buybacks sharply in 2009, when shares were cheapest. Repurchases follow cash flow and confidence more than valuation, which is why they tend to shrink just when they would do shareholders most good.

Borrowing no longer pays

When investment-grade companies could borrow at about two per cent, one with an earnings yield of six per cent made money on every share it bought back with debt. Once the tax relief on interest was counted, the cost of borrowing was trivial, and treasurers could retire equity at a large discount. That trade has vanished in the government bond sell-off.

High-grade corporate bond yields are heading towards five per cent, so the cost of new debt now often exceeds the earnings yield of the company issuing it. Borrowing to buy back stock now shrinks free cash flow per share. Put the one per cent tax on top of that negative spread and the value of buybacks to shareholders falls for good.

Cash-rich companies face a milder version of the same sum. Six-month Treasury bills now yield more than 3 per cent, so money left on the balance sheet earns something again, and every dollar spent on repurchases gives that return up. A board that once weighed its earnings yield against a deposit rate of zero now has to beat a risk-free yield that is climbing with every Federal Reserve meeting, before paying the new tax.

Boards rethink the cash

The new arithmetic forces boards and audit committees into an awkward rethink. Over the past five years buybacks were a handy way to hand back cash that had no obvious investment home. They were more flexible than a regular dividend, and they offset the dilution caused by executives' share awards.

Under the new law that flexibility carries a price. The tax falls on net repurchases, after deducting shares issued during the year, so a buyback that merely mops up employee share awards escapes it, while anything beyond that sends a cut to the US Treasury for the privilege of shrinking the share count. A company retiring $10bn of stock a year, net of issuance, would owe $100m, money that neither shareholders nor bondholders see. And as debt raised in the easy-money years falls due over the next three years, the cash will be needed to pay down borrowing more than to retire shares.

Dividends regain ground

The levy also tilts the old contest between the two ways of returning cash. Taxable shareholders have long preferred buybacks, because a repurchase lets them defer capital-gains tax until they sell, while a dividend is taxed on receipt. The excise leaves dividends untouched and trims that advantage, and it arrives in the same law as a 15 per cent minimum tax on the book profits of companies earning more than $1bn, which will raise the tax bill of some of the biggest repurchasers. Companies with stable cash flows and few growth projects, such as utilities, consumer staples and tobacco, may find a higher regular dividend the cheaper commitment. Holders who valued buybacks for their tax efficiency, including many wealthy individual investors, lose a little of that edge.

A rush before January

The case against this view is that one per cent is a rounding error beside a normal day's movement in a share price, and that groups sitting on net cash, the large technology companies above all, never needed to borrow to buy back stock. That is fair for the richest balance sheets. It misses the many companies that used the bond market to fund repurchases, and it ignores the timing incentive the law creates. Because the tax applies only to purchases made from 2023, boards have every reason to pull buybacks forward into the last months of this year, which would flatter the fourth quarter and make the decline that follows look steeper.

The pull-forward has limits of its own. Many companies restrict discretionary repurchases in the weeks before each earnings release under their own trading policies, unless a pre-arranged plan is in place, so the window for accelerating purchases before January is narrower than it looks. Accelerated share repurchase agreements with banks can compress the buying into a few weeks, at the cost of paying the bank's fee and bearing its hedging costs.

Treasury guidance on how the tax is calculated, fourth-quarter repurchase totals and the spread between corporate borrowing costs and earnings yields will show how much of the old habit survives. Automatic buybacks have hit their financial limit. With borrowing costs above earnings yields and the Treasury taking one per cent of every share cancelled, buybacks will shrink from 2023, and treasurers will have to find real projects for the money. Much of the cash will be kept back for debt service and working capital, and share prices will have to rest on operating results, with less help from engineered scarcity, a shift that will hit the most indebted repurchasers hardest.