“I was very interested to see you commenting on The PowerShares Buyback Achievers ETF (PKW) recently.  This has been a favourite of mine for a long time due to its consistent lead over the broader indices.

" You comment that the advantages of buybacks will be eroded once borrowing is no longer so cheap, and that since the PKW has led on the upside and is now overextended, maybe it will soon commence a drawdown.

"I had always assumed that its outperformance is not so much due to the difference between the yield and the cost of borrowing, which must be quite marginal in terms of the company's performance, but to the fact that the company's ability to repurchase shares in the first place shows that it is in a financially healthy condition. That is, it is the selection process of the index which gives the outperformance, not the buybacks themselves.

"In this case, one could surely expect the PKW to continue outperforming, rather than leading on the downside in any coming correction.

"What do you say to this idea?"

Eoin Treacy's view My comment - Thank you for this detailed email which is sure to be of interest to subscribers. Let’s consider why a company buys back shares. Equity is a form of credit and contributes to the overall cost of capital. The performance of a company’s shares also has a considerable effect on public perceptions of the firm’s overall health. Therefore if a company can lower its cost of capital and improve perceptions of its health then the case for buybacks is well made. Paying dividends on the other hand is considered by some as an inefficient use of capital, although this attitude has moderated somewhat since the yield on government paper is still relatively uncompetitive.

The question then is how companies are paying for buybacks. If, as you suggest, they are funding buybacks from large cash balances this can viewed as supportive, but it is by no means the only way of funding buybacks. Corporate bond issuance hit records this year and last. Some of that new debt is being used to pay down more expensive legacy loans and bonds but a significant portion has also been used to buy back shares and to increase dividends.

So far BBB spreads have been relatively steady suggesting that while absolute borrowing costs have surged, the relative performance of corporate debt still suggests complacency in the sector. A break above 200 basis points would suggest the era of ultra-low corporate borrowing costs is at an end and this will inevitably have the greatest effect on the performance of shares that have funded buybacks and dividend increases with debt.

Companies that fail to buyback 5% of their free float will be dropped from the PKW ETF. However it is also worth considering that the stock market is a discounting mechanism and if the primary support for the sector’s outperformance is removed that there is a risk of underperformance. The PKW/S&P 500 ratio has accelerated higher this year. The first clear downward dynamic is likely to suggest a peak of at least near-term and potentially medium-term significance.