Jun 15, 2020
• The Fed risks creating distorted signals with its bond support program
• Hertz in bankruptcy raises equity!!
• Investors increasingly have to turn to equities for income even allowing for dividend cuts
• Government bond yields below equity yields and inflation
“A company for carrying out an undertaking of great advantage, but nobody to know what it is.”
Precisely 300 years ago, the above epithet was used in what today would be termed the issuing documentation of a company that was part of the so-called South Sea Bubble. The speculative fervour of this episode has become legendary, and even the genius Sir Isaac Newton was taken in by the hype and lost a fortune.
This week past has seen something that might well go down in history as similar for hype: the new equity issued by Hertz, the well-known car rental company that had just filed for bankruptcy. The internet has been abuzz with commentary. In one camp are the market professionals, who for the most part, view the effort to raise equity capital for a bankrupt firm with a mixture of amusement and scorn. In the other, there is the new crop of day traders, who are spreading out fanwise from their chat rooms and making much noise. The noise is all about a new strategy in equity markets: buy whatever has fallen the furthest, because sooner or later those stocks will be bailed out.
We don’t want to comment in too much detail about the merits of this new investment style, except to note Mr Keynes’ well-known warning that the market can stay irrational for longer than most of us can stay solvent. It is quite likely that buying the equity of a bankrupt firm will have a sobering effect on the net worth of the majority of those who choose to take the plunge, but perhaps not as soon as some may believe.
The Fed has opened Pandora’s box. By effectively underwriting the credit market, it has signalled its deep unwillingness to tolerate market volatility, especially if that volatility is to the downside. It is clear from the way the Fed’s support is structured that not all credit assets will be eligible for assistance. There is no explicit commitment to keep zombie firms alive – companies with ratings below the threshold risk the Fed casting them adrift. In the structured credit market, the dislocation is for real, and distressed opportunities are forming. This part of the market is mostly inaccessible to retail investors, however. Not so the equity market, where anyone is welcome to buy anything on any investment thesis.
If we accept that the Fed’s actions have given rise to a new belief that markets will only go up from now because there is a policy commitment to keep the party going, the implications are disturbing. Just before Hertz announced its equity offering, its bonds were trading around 30 cents, consistent with a firm in chapter 11. Usually, when a firm’s bonds price so low, the equity is close to worthless. Close, but not always zero: there can be a small residual left, which is considered an “option premium”: a very speculative bet on a recovery. In the case of Hertz, a sudden surge in this option value (the stock price almost doubled) led to a swift decision to help feed the frenzy and to issue equity. The bond price rallied to above 40 cents. There is now a group of investors who are willing to take a speculative bet on the recovery potential of a company that has been decimated by COVID and faces an existential threat to its business model post-COVID. The winners are the bondholders, who now have a whole new source of funding for the restructuring process.
Here is the hazard: if this new procedure becomes accepted practice, the Fed’s mantra that it tries not to react to market bubbles will begin to wear thin. Its very presence is creating a frenzy in the market. It threatens to up-end a respected practice of dealing with bankruptcy, where there is an accepted priority of claims and an organized way of re-shaping a company to either survive in leaner form or be wound up. There is always the tacit understanding that if things don’t work out, the market will assign a deeply discounted price for the debt of such firms. For example, Lehman Brothers debt, in the end, paid bondholders around 10 to 12 cents to the dollar. If bondholders think (as they might, given this example) that there is a new-found spigot of cash to inflate the value of defaulting bonds, it will distort their decision to lend in the first place, or make them more willing to accept worse pricing than they otherwise would.
How does it end? If the Fed does not find a way to communicate more clearly its intention around junk bonds, (the bankruptcy process and further support for downgraded bonds), the presumption of a perpetual rally could persist. Only when the reality of the post-COVID corporate earnings outlook takes hold might reality dawn.
strong style=”color:#f06735;”>One of the significant challenges for investors from this crisis is the disappearance of yield. US government bond yields have dropped from 1.5% to somewhere around 70 basis points. Even in the high yield and emerging market debt markets spreads have contracted from the peaks of March and leave absolute yields in the 3% to 5% range at best.
In the equity market following an equity income strategy has proved a disaster for investors. Cuts in dividends for banking stocks and oil companies have undermined dividend payments at the aggregate index level. Since the start of the year analysts’ dividend forecasts for the UK FTSE-100 has dropped by 32%. The analysts’ estimate for the Eurostoxx-50 dividend is down by 24% and for the S&P500 a more modest 6%.
However, as the dust settles on dividend cuts, the fact that many equity markets offer substantially more yield than their respective bonds markets should encourage investor support. The US equity dividend yield less the long-term bond yield is at close to the highest it has been. The current spread of 124bps is above almost all periods in the past 13 years. In Europe, the gap between the Eurostoxx-50 dividend yield and German ten-year bund yield is at the top end of the 15-year range. Even compared to the higher Italian government bonds yields, the estimated Eurostoxx dividend yield is over 200bps higher.
US and European government bond yields are not just coming up short against their respective equity markets but also against inflation. Both the German and US government 10-year bond yield is a fully 100bps below the inflation rate. German 10-year government bond real yields have been persistently negative since 2016. Would investors continue to buy bonds that offer negative real yields unless they thought inflation was about to fall substantially from here?