07.01.2020
And all for one
Now that's a public-private partnership.

Now that’s a public-private partnership. Yesterday, the Treasury Department announced it will lend $700 million in coronavirus stimulus funds to trucking firm YRC Worldwide Inc. and, as part of the deal, will receive a 29.6% equity stake in the company.  Treasury noted that YRC qualified for assistance under a $17 billion lending fund established in March for companies deemed essential to national security.

Oddly enough, that triple-C-rated pillar of national defense has left its financial guard down: total debt rose to $1.2 billion last year from $870 million at the end of 2018, while cash dropped to $110 million from $270 million the year prior.  Last fall, the company borrowed $600 million via a term loan from Apollo Global Management.  The loan, issued at a 750 basis point spread over Libor, changed hands yesterday at 87 cents on the dollar.  It’s a fair guess it rallied today.

All ahead sideways
A sigh of relief for North America's largest uranium miner.

A sigh of relief for North America’s largest uranium miner. Last week a Canadian appeals court ruled unanimously in favor of Cameco Corp. (CCJ on the NYSE and Toronto exchange) in a tax dispute dating back to 2003 with the sore-losing Canadian Revenue Authority.  The CRA had sought up to C$2 billion ($1.5 billion) in back taxes, a material sum relative to Cameco’s C$5.3 billion enterprise value. 

While the removal of that long-standing irritant is welcome news, Cameco management and uranium bulls continue to face a market which stubbornly remains in the doldrums.  Spot uranium (U3O8, a.k.a. triuranium octoxide) now trades at $33 a pound, down from a peak of $136 a pound in 2007 and $73 in 2011, before the Fukushima disaster cast a pall over all things nuclear. Cameco shares have remained stuck near $10 for years, compared to more than $55 a share in 2007, thus far thwarting the bull crowd (Grant’s among them).  

Might the price of so-called yellowcake be set to, at long last, reverse its post-2007 torpor into a new bullish regime?  It’s a commodity that doesn’t lend itself to whipsaw price moves.  The June 1, 2018 edition of Grant’s described uranium’s leisurely fundamental pace:

The ‘uranium cycle’ has a timeline all its own. Supply is slow to pick up on changes in demand, and demand is slow to respond to changes in supply. It can take a decade to develop a mine or build a reactor. A decade, too, is sometimes the measure of a complete uranium price cycle, from too low to too high. 

Improved supply and demand dynamics are, of course, central to such a shift. While the pandemic has crimped uranium demand, the damage looks to be modest on a relative basis, as consulting group UxC estimates a 3.3% demand drop for full-year 2020.  For context, the U.S. Energy Information Agency expects global oil demand to drop by 8.3% from a year ago, while the IMF pegs overall global growth at minus 4.9% for 2020. 

Jonathan Hinze, president of UxC, tells Barron’s today that: “Demand for nuclear power hasn’t dropped dramatically due to COVID-19 as most reactors operate as baseload power suppliers and are usually the last to be taken off the grid.” Indeed, Hinze anticipates “relatively robust” demand over the next six to 12 months. 

At the same time, factors both novel and longstanding conspire to keep a lid on supply.  According to the September 2019 Nuclear Fuel Report, global uranium exploration mine development expenditures fell to $663.7 million in 2016 from $2.12 billion in 2014, a 69% decline. Last year, nuclear reactors consumed 187 million pounds of U3O8, well above the 140 million pounds in new supply, according to UxC. Utilities and uranium enrichment companies filled that supply hole by destocking inventory.

As miners have reacted to the price lull by taking supply offline, the pandemic has provided a further shove in that direction. Thus, on March 23 Cameco announced it had shuttered its Cigar Lake facility (annual capacity of 18 million pounds) in northern Saskatchewan “for an indeterminate period of time” thanks to the bug, as the remote facility offered little in the way of medical care in the event of an outbreak. In November 2017, the company temporarily shut its MacArthur River and Key Lake Mill (which produced 28.4 million pounds in 2015) on account of low prices.  That pause, expected to last 10 months, remains in effect today. 

Those shut-ins can be expected to ripple through the market for some time. At a Bank of America conference on May 13, Cameco CFO Grant Isaac explained: 

We go through times of unplanned supply disruptions, it does highlight for our industry, and for those who rely upon the industry for nuclear fuels, that through the years, we've seen a significant degree of geographic and geologic concentration in the supply of uranium.

And so, an upset at any one location ends up having a fairly big impact on the overall industry because there are so few players and so few sources of supply.

In the meantime, Cameco’s solid balance sheet should allow it to capitalize on any turn in fortunes.  Triple-B-minus rated CCJ sported net cash (C$1.2 billion of cash, compared to C$1 billion in debt) as of March 31 and has generated positive free cash flow in each of the last five years, while its senior unsecured 5.09% notes of 2042 trade at 110 cents on the Canadian dollar, for a yield-to-worst of 4.35%. 

For a detailed bullish analysis of Cameco and a trio of other industry players, see the March 6 and April 17 editions of Grant’s

Recap July 1

A third straight rally extended the S&P’s gain for the week so far to 3.6%, and pushed the broad index to within 8% of its February high water mark.  Treasurys came under modest pressure, with the 30-year yield rising to 1.43%, while gold pulled back to $1,780 an ounce and WTI crude slipped below $40 a barrel.  The VIX tumbled below 29, extending its three-day loss to 18%.

- Philip Grant

06.30.2020
It's a kind of magic

Here’s Rich Greenfield, media analyst and partner at LightShed Partners, on Twitter: 

Just spoke to union leaders representing Walt Disney World cast members in Orlando - Confirmed that Disney is NOT testing employees before they return to work next week, including stage performers who can't wear masks – testing is employees' responsibility, not Disney’s.

The Running Man
Supermarket sweep, 2020 edition.

Supermarket sweep, 2020 edition.  From May 19 to June 16, the Federal Reserve bought $5.1 billion in corporate credit ETFs under its Secondary Market Corporate Credit Facility according to Bank of America. That shopping spree was enough to push the central bank towards the top of the holders list in a number of the biggest such ETF products, including the third largest in the $54 billion iShares iBoxx USD Investment Grade Corporate Bond ETF (ticker: LQD), as well as the second- and fifth-largest holders in the $29 billion Vanguard Short-Term Corporate Bond ETF (ticker: VCSH) and the $36 billion Vanguard Intermediate-Term Corporate Bond ETF (ticker: VCIT), respectively.

There is plenty of in-house appetite for more. Fed chair Jerome Powell declared yesterday that: “The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in containing the virus. . . [recovery] will also depend on the policy actions taken at all levels of government to provide relief and to support the recovery for as long as needed.” 

Mr. Market anticipated that message, as junk bond issuance in the first half of the year came to a record $180 billion, according to Dealogic. Investment-grade corporate bond issuance for the first six months footed to a monster $840 billion, nearly double the previous half-year issuance record set in 2016.  Kevin Foley, head of global debt capital markets at J.P. Morgan, summed up the prevailing mentality to The Wall Street Journal: “It’s been ‘take the money and run.’” 

Park it
Musical chairs in food delivery.

Musical chairs in food delivery.  Various press outlets report that Uber Technologies, Inc. is cooking up a formal bid – The Wall Street Journal pegs the likely price at $2.6 billion – for the food delivery service Postmates to pair with its Uber Eats business. Time is of the essence for Uber, relays the Financial Times, “because a private equity buyer was also competing to buy Postmates.”  The latest merger efforts follow European rival Just Eat Takeaway plc.’s $7.3 billion, all-stock deal with Grubhub on June 10, which beat back Uber’s reported approach. 

That determination to size up its Uber Eats division comes as the ride-share giant looks to retrench from other non-core businesses to save money.  Bloomberg reported that CEO Dara Khosrowshahi told staff in an email last Thursday that Uber will “deprioritize” a number of finance-related projects, a decision which coincided with Uber Money head Peter Hazelhurst’s decision to step down from his role.  That follows announced layoffs last month totaling 25% of the total workforce. 

Of course, the core ride-share business is no great shakes. Since the start of the pandemic, ridership dropped some 70% from a year ago, Khosrowshahi announced earlier in June.  Then again, the status quo wasn’t exactly lucrative, as Uber posted adjusted Ebitda of negative $7.3 billion last year, compared to a $2 billion adjusted Ebitda loss in 2018. 

Meanwhile, regulators and politicians look to do a little disrupting of their own. Last week, California Attorney General Xavier Becerra said he will seek a court order immediately to enforce Assembly Bill 5, the legislation passed in 2019 to require so-called gig economy companies to classify their workers as employees instead of independent contractors (thus putting the employers on the hook for healthcare expenses along with Social Security and Medicare taxes).  By way of response, Uber spokesperson Julie Wood told the press: “Trying to force drivers to give up their independence 100 days before the election threatens to put a million more people out of work at the worst possible time.”

While politics and the pandemic play their roles, structural deficiencies may be the ultimate hindrance for the industry and their investors.  Addressing the Grant’s fall 2019 conference audience from the podium at the Plaza Hotel, noted transportation consultant-turned ride-share authority Hubert Horan didn’t mince words in providing his assessment:

Uber has no hope of sustainable profits in competitive markets. A company with $20 billion in losses in years six through ten is not rapidly growing into profitability like Facebook or Amazon. Uber’s economics are totally uncompetitive. They are actually a higher-cost, less efficient producer than your traditional yellow-cab company.

All of Uber’s popularity and growth has been the result of massive, predatory subsidies that were used to drive out the more efficient operators. The market shows no willingness to pay the true cost of Uber’s services. Reversing these losses would be one of the biggest turnarounds in corporate history, and Uber doesn’t have a profitable core to restructure around.

Recap June 30

Another green day for stocks left the S&P 500 down by less than 5% year-to-date at the mid-way point for 2020, up a cool 38% from its March 23 low.  Treasurys reversed early gains in bear steepening price action, with the 30-year yield rising above 1.41%, while gold jumped nearly 1% to $1,798 an ounce, after climbing above $1,800 intraday for the first time since 2011.  The VIX closed south of 31 for a three-week low. 

- Philip Grant

06.29.2020
U.S. Blues

A little less help for Uncle Sam. While the Fed has scaled back its Treasury purchases to $80 billion per month from a March peak of $75 billion per day, ballooning fiscal deficits ensure that plenty of new government bond supply will need to find a home.   

With projected net issuance of more than $4.7 trillion this year (nearly quadruple that of 2019), analysts at J.P. Morgan calculate that, at the current pace, Fed purchases will account for only 25% of long-term Treasury supply in the back half of the year.

In other words, plenty of “safe” assets to go around. 

Pledge pin

Caixin reports today that 83 tons of gold bars used as loan collateral by Nasdaq-listed Wuhan Kingold Jewelry, Inc. (ticker: KGJI) “turned out to be nothing but gilded copper.”  That’s bad news for upwards of a dozen Chinese financial institutions, which issued more than RMB 20 billion ($2.8 billion) in loans backed by the fool’s gold to the company over the last five years. 

Asked by Caixin if the pledged gold was fake, Kingold chairman Jia Zhihong replied: “How could it be fake if insurance companies agreed to cover it?” 

Disbelief is understandable, considering the size of the potential fraud. That 83 ton cache would be equivalent to 22% of the Middle Kingdom’s annual output and nearly 5% of its gold reserve as of last year. 

Deal doozy
What's old is new again.

What’s old is new again. Last Thursday, U.K.-based insurance retailer The Ardonagh Group Ltd. issued a £1.58 billion ($1.94 billion) unitranche loan to a consortium of private credit investors led by Ares Management. That’s the largest such loan on record.  

The deal is notable not just for its size. The financing package includes $500 million in 11.5% pay-in-kind toggle notes (which allow issuers to pay the coupon in more debt rather than in cash) due 2027, priced at 99 cents on the dollar for an 11.72% yield.  That’s above initial price talk of 10.5% to 11%. If Ardonagh opts to pay interest in scrip rather than cash, the coupon jumps to 12.75%. 

Lenders may not want to count on much near-term income from the deal. On last week’s conference call, the company indicated it will exercise the PIK option immediately. 

Use of proceeds includes the financing of a pair of acquisitions—acquisitions purchased from funds managed by Ardonagh’s own private-equity investors, HPS Investment Partners and Madison Dearborn Partners. 

Last week, Fitch downgraded Ardonagh’s long-term issuer default rating to single-B-minus from single-B, on account of gross leverage above seven times projected funds from operations over each of the next three years. 

Neither is an improved interest profile part of the corporate calculus, as R.W. Baird director Brian Dirubbio noted last week. According to Dirubbio, the new financing actually increases Ardonagh’s weighted average coupon. 

The transaction rather confers other benefits. By funding the acquisition of businesses that dwelled in the investment portfolios that the p.e. sponsors manage, the bond offering will allow the p.e. pair to “recoup some of the capital they have poured into Ardonagh since 2015 and 2016.” Dirubbio concludes that “the company cannot afford to pay additional cash interest given its current cash flow profile.”

More broadly, the return of the PIK structure signifies the bond market’s forgiving mood, as the prior cycle was unkind to those lenders. According to Moody’s Investors Service, issuers of PIK-toggle debt defaulted at a 30% clip in 2009, compared to a 17% baseline for similarly-rated credits. 

Recap June 29

Score one for the bulls, as stocks firmly erased overnight weakness to leave the S&P 500 1.5% in the green, narrowing year-to-date losses to 5.5%.  The Treasury curve steepened a bit, with the 2-year yield falling below 16 basis points for the first time since mid-May, while WTI crude rose back near $40 a barrel and gold held at $1,772 an ounce.  A late selloff pushed the VIX below 32. 

- Philip Grant

06.26.2020
Fork in the road
What a pile of junk.

What a pile of junk.  June has been a month to remember for high-yield bonds, as new supply of $50.6 billion tops the prior record of $46.4 billion set in September 2013 with days to spare.  Year-to-date issuance foots to $205 billion, up a cool 71% from the same time last year. 

That’s not to say that all junk issuers are created equal, as the Financial Times notes today that the recent supply surge has been concentrated in the upper echelons of the credit spectrum. Thus, data from Refinitiv show that 57% of the $140 billion in issuance over the past 14 weeks has been double-B-rated credits, up from 42% in the first two months of the year. At the same time, the share of debt issued by single-B-minus rated companies fell to 3% since March, compared to roughly 10% in January and February.

The enthusiasm for the upper crust of sub investment-grade bonds is also reflected in price action.  On the one hand, the double-B-rated segment of the market has lost a mere 0.61% year-to-date.  Triple-C’s, on the other hand, are down by 12.2%.

Ratings may be dictating the proceedings, but there are exceptions.  On Wednesday, American Airlines, Inc. priced a $2.5 billion first-lien 11 3/4% notes due 2025.  Issued at 99 cents on the dollar, the double-B-minus-rated securities have since fallen to 96.4 cents, for a 1,242 basis point spread over Treasurys.  For context, the triple-C-portion of the Bloomberg Barclays High Yield Index sports a 1,165 basis point option-adjusted spread. 

Down to the wire
The Wall Street Journal reported yesterday that higher-ups at Credit Suisse

The Wall Street Journal reports that higher-ups at Credit Suisse are examining a handful of structured investment vehicles with exposure to Wirecard A.G, which has filed for bankruptcy following revelations of an accounting scandal including fictitious cash balances. Of particular focus: The multiple investment roles that SoftBank Group Corp. played in transacting the complex securities, and associated potential conflicts of interest. 

It wasn’t supposed to be this way, as SoftBank managed quickly to recoup its €900 million ($1.01 billion) convertible bond investment in Wirecard last year while maintaining potential upside in the German fintech company through call options. Recall that last September, an unnamed senior executive at SoftBank told the Financial Times that the move “was inspired by Warren Buffett, who has a record of making highly structured investments in seemingly troubled companies that then benefit from his reputation” (Almost Daily Grant’s, June 19). 

Instead, the unfolding reputational fallout comes as SoftBank looks to make wholesale changes to its portfolio structure following a $13 billion operating loss over the 12 months through March 31.  Earlier this week, the firm sold $14.8 billion worth of shares in T-Mobile U.S., Inc., equivalent to roughly half its position in the carrier (SoftBank intends to sell a total of $20 billion worth of TMUS).  

Even formerly sacred cows are up for veterinary reappraisal. SoftBank famously acquired a 25% stake in Alibaba Group Holding Ltd. for $20 million in 2000; today that investment is worth $150 billion. Last month SoftBank CEO Masayoshi Son indicated he may sell up to $11.5 billion worth of BABA shares.  Something appears afoot on that score, as Son yesterday announced he would leave the Alibaba board of directors after a 15-year stint, a month after Alibaba CEO Jack Ma departed the SoftBank board. 

Son is not using all of the sales proceeds to improve balance sheet quality, however. Yesterday, SoftBank announced a fresh ¥500 billion ($4.7 billion) share repurchase program.  That’s equivalent to 5.7% of shares outstanding and is the third such buyback authorization in the last two months. 

Some are less than impressed with the wheeling and dealing. Earlier today, Moody’s Investors Service cut its outlook on SoftBank to negative, citing “the potential for substantial changes in its credit profile as a result of its large recapitalization plan,” along with “thin” interest coverage and SoftBank’s “aggressive financial policy and associated governance concerns.” 

By way of response, SoftBank issued a statement declaring that: “SBG has provided no information to Moody’s since withdrawing from its rating service on March 25, 2020. Therefore, it is unclear what Moody's intention is to comment on SBG, nor what information it uses to understand SBG's situation and assess our creditworthiness.”

The negative outlook is apparently mutual. 

Recap June 26

Stocks fell bigly, with the S&P 500 losing 2.4% to finish the week nearly 3% in the red, while a bull-flattening Treasury rally left the 2-, 10- and 30-year yields at 0.17%, 0.64% and 1.37%, respectively. WTI crude slipped to $38 a barrel, gold reached another post-2012 high at $1,771 an ounce and the VIX closed just above 35. 

- Philip Grant

06.25.2020
Field of screams
In for a Penney, in for a pound.
In for a Penney, in for a pound. Yesterday, The Wall Street Journal reported that Simon Property Group, Inc. and Brookfield Property Partners, Inc. are “exploring” a bid for bankrupt retailer J.C. Penney Co., a move which would follow similar transactions for distressed apparel retailers Forever 21, Inc. and Aeropostale, Inc.  
 
This follows an announcement in early May that Brookfield Asset Management would spend $5 billion propping up retailers laid low by the pandemic, with the funds earmarked to acquire non-controlling stakes in enterprises with pre-lockdown revenues of $250 million and above. “They are doing this to keep the retailer alive, so that Wall Street doesn’t see the declining [rental] income,” Nick Egelanian, president of retail consulting firm SiteWorks, told the Journal. “The business model has been cracked for a long time.”
 
So-called anchor tenants (usually department stores) pay discounted rents in return for generating traffic to the rest of the mall, including to smaller, “inline” tenants, who reciprocally pay more. Department stores no longer draw traffic – some not even breath. And, if more than one anchor retailer in a mall goes dark, co-tenancy clauses are tripped, allowing inline tenants to slash their rents. This may be the driver of Brookfield’s and Simon’s interest in Penney.
 
It’s not just the retailers themselves which are taking on water. Bloomberg reported last week that The Mall of America (the third largest such facility on the continent) failed to make a $7 million interest payment on its $1.4 billion mortgage.  That’s its third straight missed monthly payment.
 
***
 
The drastic changes underway in the retail and office property landscape shine the spotlight anew on the Brookfield real estate empire.  Bermuda-based Brookfield Property Partners, L.P. (BPY on the Nasdaq) is the flagship real-estate vehicle of Canadian investment behemoth Brookfield Asset Management, Inc. focusing on office space and so-called class-A malls, while Brookfield Property REIT, Inc. (BPYU on the Nasdaq), a wholly-owned subsidiary, is a retail pure play. Despite the differing asset composition, shares in the pair are fungible, i.e., they share equal rights to dividend income, can be exchanged on a one-for-one basis upon request, and trade in virtual lockstep.
 
While BPR’s business model has long been in short-sellers’ crosshairs with a 37% short interest at present, up from 21% in the fall, the more diversified BPY sported just a 1.2% short interest at the time of a bearish Grant’s analysis on Nov. 29, 2019 and now has 8% of its shares sold short.  Since we had our say, the pair is down by 44% after accounting for dividends. 
 
That precipitous slide leaves the entities sporting some eye-catching metrics.  At $10.2 per share, BPY trades at a cool 64% discount to its stated net asset value for a 13% dividend yield. 
 
 
The Brookfield ownership structure.  Source:  Company filings 
 
If the labyrinthine corporate structure is a head-scratcher, aggressive leverage is a more transparent concern. BPY carries net debt of $53.4 billion, equivalent to 13.3 times trailing 12- month Ebitda. 
 
Untimely deal activity didn’t help on that score. In August 2018, BPY doubled down on malls, closing a deal to buy the remaining two-thirds it didn’t own of mall-based real estate investment trust GGP, Inc. for $15 billion. Vince Tibone of Green Street Advisors told Grant’s last fall that Brookfield is more exposed to department stores per mall than other A-mall REITs. 
 
An April 28 analysis from Green Street argued that the pandemic “is pulling forward several years of retail fallout.” The analysts concluded that “more than half of all mall-based department stores will close by the end of 2021.” 
 
While that dire forecast is a speculative one, bullish facts are also up for debate.  BPY calculated its retail occupancy at 95.1% as of March 31, up from 94.9% a year ago.  Yet an anonymity seeking short seller advised Grant’s in November that a real estate consultant who canvassed 21 of the 123 Property Partners malls assessed the occupancy level at 87.1% among non-anchor properties, and 82.7% occupancy including anchor tenants.  
 
Then, too, annual management fees to Brookfield Asset Management explain some of the NAV discount.  This year BPY will shell out some $96 million in fees, using the first quarter’s annualized pace.  Applying 25 times multiple to that payment (as BAM does in its own NAV calculation) yields $2.4 billion, a material chunk of the $27.1 billion in net equity attributable to shareholders. 
 
The bond market has improved its assessment of the situation as asset prices have come roaring back in recent months. Thus, Brookfield Property REIT’s first lien 5 3/4s of 2026 last traded at 86 cents on the dollar for an 8.85% yield-to-worst, up from a low of 72 cents on March 23. 
 
Mr. Credit Market may have cheered up, but the rating agencies, less so. On April 8, S&P Global, which appraises BPY and BPYU  triple-B and triple-B-minus, respectively, slapped a negative outlook on BPY, citing a likelihood “that the company's credit protection measures will deteriorate over the coming year, particularly as we don't anticipate asset sales to materialize as previously expected.”  Wiggle room is slight, as the ratings agency believes that BPY has “sufficient covenant headroom for forecast Ebitda to decline by 10% without the company breaching [debt] covenants.” 
 
The company is doing its best to make sure that doesn’t happen. The Financial Times reported Monday that Brookfield continues to aggressively collect rent payments from outlets which were forced to close due to the pandemic, while simultaneously asking its own lenders for forbearance. 

 

 

QE progress report
Reserve Bank credit fell to $7.01 trillion, down $75 billion from last week’s reading and is the lowest figure since May 20. That’s not to say that financial conditions can be described as restrictive, as the three-month annualized growth rate of interest bearing assets on the Fed’s balance sheet stands at 540%.
Recap June 25

Stocks enjoyed a late rally as the S&P 500 finished 1.1% in the green, narrowing losses for the week to 0.5%, so far.  Treasurys finished little changed, with the 10- and 30-year yields at 0.68% and 1.43%, respectively.  Gold held at $,1763 an ounce, WTI crude at $39 a barrel, and the VIX dropped to 32, down 5% on the day. 

- Philip Grant

06.23.2020
Here, there and everywhere
More anything? More everything!

More anything? More everything!  As the monetary response to pandemic-related pain has far outstripped that of previous crises, central bankers can look with satisfaction at evidence of their successes: Namely, a 40% S&P 500 rally off the March 23 low and retracement of high-yield credit spreads to 600 basis points over Treasurys from a high of 1,100 basis points on that same grim day.  Yet policymakers past and present, along with other constituencies, are expecting more to come. 

While Fed chairman Jerome Powell has repeatedly played down the prospect of negative rates in the U.S., Mr. Market isn’t so sure: This morning the January 2022 Fed Fund futures contract traded above 100, implying that overnight interest rates will be set slightly below zero on that future date (thank you, Alex Manzara). Anecdotal indicators are also apparent, as the Financial Times reported June 15 that the Bloomberg data service told users to consider switching the standard dollar-denominated interest rate options pricing model to one incorporating the possibility of a sub-zero funds rate, “as a preventative measure.” 

As for so-called yield curve control (or committing to purchase sufficient quantities of government bonds to keep rates pegged at desired levels), public statements suggest more approval from the monetary mandarins. New York Fed president John Williams appeared to jawbone for the policy last month, telling reporters on May 27 that the central bank is “thinking very hard about rolling it out.”  

For his part, the Fed chair has hedged his bets. Powell told Congress last week that the idea had come up in a recent meeting of the Board of Governors, but “it’s not something we’ve all decided to do.”  

To be sure, yield curve control, which had its 21st century debut at the Bank of Japan in fall 2016, has its limitations. In a study published Monday, the New York Fed concluded: “Has yield curve control been a success? Seemingly not on the inflation front.”  But financial markets are more pliable: “Under the new policy, the BoJ has been able to exert fairly close control over the term structure of interest rates without resorting to large-scale interventions in the Japanese government bond market.”

Stateside, the prospect of overtly capped Treasury yields is a bullish siren song. “It depends on the form and the price but broadly speaking it’s the green light to carry on with the QE trade – buy everything regardless of valuation,” James Athey, senior investment manager at Aberdeen Standard Investments, told Bloomberg. 

While “buy everything” has been a perfectly successful mantra post-March 23, “buy deep junk” has fared even better, as Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, concluded in a June 17 analysis for S&P’s LCD division.  From the March 23 lows to June 8, a sample of 30 companies rated single-B-plus and below (i.e., the junkier end of junk) racked up average gains of 108.5%, topping the 74.6% gain in the double-B-plus to double-B-minus ratings bucket. In addition, 11 of the 30 selected stocks within the “extra junk” group doubled and four tripled over that ten week period, while six out of 30 for the higher-rated sample doubled and none tripled. 

The tidal wave of liquidity that coincided with the historic spring rally has abated, for now at least. Weekly sequential growth in Reserve Bank credit (meaning total interest-bearing assets on the Fed’s balance sheet) has remained below 1% since late May and declined outright last week for the first time since February.  By contrast, Reserve Bank credit grew by a combined 25% in the two weeks ended April 1. 

Lest anyone be concerned about a suddenly passive Fed, former New York Fed president William Dudley wrote in a Bloomberg Opinion column Monday that the balance sheet could “conceivably” top $10 trillion by the end of the year. That compares to a bit more than $7 trillion currently and just over $4 trillion when the bug bit.  Dudley expounds:

By reducing the supply of safe assets and increasing the amount of deposits that the private sector must hold, the Fed generates a demand by the private sector for more risky assets. The result is a rise in financial-asset valuations and an easing of financial conditions. The Fed’s asset purchases change the mix of assets available to be held by private investors and this influences asset valuations.   

Forget Instagram, and behold the real influencers. 

Recap June 23

Stocks finished off their best levels of the day, but early gains were enough to leave the S&P 500 less than 8% from its February high-water mark, while the Nasdaq 100 ascended to a fresh record close of its own. The Treasury curve steepened a bit thanks to modest weakness at the long end, as the 30-year bond yield rose to 1.49%.  Gold rolled higher again to $1,770 an ounce,  WTI crude pulled back to $40 a barrel and the VIX held near 31.  

- Philip Grant

06.22.2020
Roll them bones
They're on a heater.

They’re on a heater.  The Roundhill Sports Betting & iGaming ETF (ticker: BETZ) has accumulated $78 million in assets less than three weeks after launching, according to The Wall Street Journal.  Usually, a new ETF takes years to grow to that size. 

“I’d be overstating if I said we expected to be at the level of assets we are now,” Roundhill Investments CEO Will Hershey told the Journal. “We knew there would be interest, but this is beyond our expectations.”  

The bourgeoning retail cohort goes a long way toward explaining BETZ’s fast start.  According to data from Robin Track, some 22,000 accounts on the Robin Hood trading platform currently hold shares in the gambling-themed ETF, up from 3,700 on June 4.  

The price revivals of bankrupt or soon-to-be-bankrupt entities such as Hertz Global Holdings, Inc. and Chesapeake Energy Corp. (with senior unsecured notes due 2028 and 2026 trading at 32 cents and 3 cents on the dollar, respectively) underscore quarantined sports gamblers’ growing impact on recent price action. 

Those Johnny-come-latelys might be well served to keep an eye on credit.  A research report last week from Verdad Advisers found that when a company’s average bond price fell below 90 cents on the dollar over the past 23 years, shareholders absorbed annualized equity returns of minus 11%.  When bonds fell below 50 cents on the dollar, an equity investor could expect an annualized 74% loss, while sub-20 cent bond prices equated to a 94% loss.  The analysis concludes: “The evidence suggests that returns come from strong credits.” 

Or, you could just put it all on red and let it ride. 

Just add helium
Financial regime change in the offing?

Financial regime change in the offing? The recent rally in gold, up 19% in the past three months to a fresh eight-year closing high, has caught the attention of some on Wall Street. 

A survey of fund managers conducted by Reuters found that some respondents have funneled nearly 10% of portfolio assets into the Money of Kings, via index funds, gold miner shares and the physical metal itself.  In addition, strategists at Morgan Stanley in the U.S. and NatWest in the U.K. have been steering clients into inflation-linked government securities to protect against a return of the inflation bogeyman. 

“These hedges in many cases look extraordinarily cheap, so why not buy them now? We could wait, then things could start to move away from us,” Colin Harte, multi-asset portfolio manager at BNP Paribas Asset Management, told Reuters.

Yet that inflation-centric view remains far from consensus, as four decades of subdued measured inflation readings and appreciating bond prices have worked their magic on broader sentiment.  For instance, the 10-year Treasury Inflation Protection Securities (a.k.a. TIPS) breakeven rate implies a modest 1.2% in annual measured inflation over the next decade.  For comparison, CPI compounded at a 1.6% annual rate over the past 10 years. 

Might an unscripted rise in the price level force TIPS to follow gold higher? A white paper this month from the Man Institute articulates the case for an upwards shift in broad price trends. 

The authors, led by Ben Funnell and Teun Draaisma, conclude that the “current recession is deeply deflationary for the next few quarters, but our analysis points to higher and more volatile inflation in the long-run, and we think the market is not priced for it.”   

Political complications arising from the post-2008 spike in wealth inequality form a key component of Man’s argument.  A reversal of the growing gap between the haves- and have-nots “can be achieved by a combination of higher fiscal spending, higher tax take and higher public borrowing, the latter all financed by the central bank. . . Above all, governments must be prepared to embark on a policy of potentially large fiscal deficits.” 

On that score, the U.S. is off and running.  Thanks to a $399 billion shortfall in May, the federal budget deficit stands at $1.88 trillion through the first eight months of the fiscal year.  That’s up 155% from last year’s pace.  

Recap June 22

Stocks caught a solid bid, with the S&P 500 rising by 65 basis points to erase Friday’s losses and close back to within 3.5% of unchanged year-to-date. Treasurys finished slightly weaker across the curve, with the 10- and 30-year yields climbing to 0.71% and 1.47%, respectively.  WTI crude jumped to near $41 a barrel for its best finish since early March, gold finished at $1,756 an ounce, and the VIX slipped below 32. 

- Philip Grant

06.19.2020
Mutual aid society
A total of 742 banks across the Old Continent

A total of 742 banks across the Old Continent borrowed €1.31 trillion ($1.46 trillion) from the European Central Bank at interest rates as low as minus 1%, the ECB announced yesterday.  The debt sale marks the debut of the so-called dual-rate system, in which banks enjoy favorable borrowing costs compared to the administered overnight repo rate, currently set at minus 50 basis points. 

Lenders eagerly availed themselves of the ECB’s generosity. Total loan size from the refinancing facility was more than double the prior high-water mark of €530 billion, set in March 2012 as the eurozone sovereign-debt crisis raged.  

The banks will use those funds to repay maturing loans, as well as to increase their holdings of government debt. “Increased sovereign exposure by banks has typically been seen as a negative in recent years,” analysts at Jefferies wrote in a recent report. “However, the policy stance is shifting and with government debt levels set to rise, it may make sense for banks to channel excess liquidity in this direction.” 

One thing is for sure:  There will be plenty of new supply to soak up that extra cash.  In its biannual financial stability review issued May 26, the ECB estimates that government borrowings across the eurozone will jump above 100% of GDP in 2020 from last year’s 86%, as budget deficits will average a projected 8% of GDP, with output declines ranging from 5% to 12%.  At the same time, some European banks are heavily exposed to their own country’s fiscal fortunes, with Italian financial institutions holding some €425 billion in Italian debt, more than 10% of the outstanding total. 

Then, too, E.U. member states face some imminent heavy lifting in terms of rolling over existing obligations, with more than 10% of total debt of France, Spain, Belgium, Finland and Portugal each coming due in the next year, while upwards of 15% of Italy’s borrowings will need to be refinanced by mid-2021. 

If the current slump persists, the ECB warns, “overvalued asset prices, low bank profitability, high sovereign indebtedness and increased liquidity and credit risks in the non-bank sector . . . [risk creating]  negative feedback loops arising from sovereign or bank rating downgrades.” 

Halo top
The spectacular meltdown of German fintech giant Wirecard A.G.

The spectacular meltdown of German fintech giant Wirecard A.G. (WDI on the Frankfurt Stock Exchange) leaves plenty of damage in its wake.  The stock has fallen 75% in the past two trading sessions after auditor Ernst & Young declared that a stated cash balance of €1.9 billion may not exist, while CEO Markus Braun resigned with immediate effect this morning.

Others involved in the fiasco face less quantifiable harm.  Last spring, SoftBank Group Corp. announced that it would invest €900 million in Wirecard via convertible debt instruments.  Instead, the deal was financed by SoftBank employees, along with the Mubadala sovereign wealth fund, and subsequently sold to investors through structured notes arranged by Credit Suisse.  

At the time of the transaction, an unnamed senior executive at SoftBank told the Financial Times that the move “was inspired by Warren Buffett, who has a record of making highly structured investments in seemingly troubled companies that then benefit from his reputation.” Subsequent events color those remarks, as the securities changed hands this morning at less than 12 cents on the euro. 

“Everything about that deal is not what you would call textbook corporate governance,” Justin Tang, head of Asian Research at United First Partners, told Bloomberg. “This is the last thing that [SoftBank CEO Masayoshi] Son needs right now as he deals with the fallout from Vision Fund losses.” 

Others are processing the news in their own way.  As the FT’s Robert Smith observes, Akshay Naheta, the managing partner at SoftBank’s Vision Fund who spearheaded the deal, took to Twitter yesterday to publicly complain that Ernst & Young had “displayed a lack of competence and responsibility.”  The executive continued: “As an organization that is meant to protect all stakeholders – creditors and shareholders – in companies, both public and private, they have failed in their fiduciary duties.”   Subsequently, Naheta locked his account. 

Recap June 19

Stocks saw modest declines on this quadruple-witching options expiration day (covering expiration of single-stocks, single-stock futures, stock-index options and stock-futures), with the S&P 500 pulling back 50 basis points to wrap up the week 2% in the green. A third straight strong showing in Treasurys left the 10- and 30-year yields at 0.69% and 1.46%, respectively, while WTI crude rose to near $40 a barrel and gold jumped to $1,742 an ounce, within range of a fresh eight-year high.  The VIX finished at 32.5, slightly lower on the day.  

- Philip Grant

06.18.2020
Bifocals wanted

Here’s Christopher Whalen, publisher of the Institutional Risk Analyst, discussing the Fed’s historic foray into the corporate bond market this morning:

No amount of open market bond purchases can fix the credit problems of the underlying issuers. Indeed, if the Fed holds these positions for any length of time, the central bank is likely to take a financial loss and become a creditor in private bankruptcies. Bad optics.

Candle in the wind
An end to corporate purgatory in the Golden State?

An end to corporate purgatory in the Golden State? On Tuesday, a federal judge approved California utility PG&E Corp.’s $59 billion reorganization plan to exit Chapter 11 of the U.S. Bankruptcy Code, marking the end of a contentious 18-month negotiation period.  

In a separate California courtroom, PCG president and CEO Bill Johnson pleaded guilty to 84 counts of involuntary manslaughter on behalf of the company, stemming from the 2018 wildfires that devastated large swaths of the Golden State.  A report released Tuesday by Butte County District Attorney Michael Ramsey alleged that PG&E showed a “callous disregard for the safety and property of the citizens of Butte County.” In 2017, the utility found that its transmission towers were 68 years old on average (compared to a mean life expectancy of 65 years), with some having been in place for over a century.  

The settlement calls for $25.5 billion in total fire-related claims, including $13.5 billion in compensation for victims.  Of that payout, roughly half will be in the form of equity in the newly reorganized entity. Insurers and local governments will be paid in cash.  That agreement comes prior to a June 30 deadline imposed by California Governor Gavin Newsom to exit bankruptcy, in order for the company to participate in a $21 billion state fund to offset future wildfire-related liabilities. 

In his ruling memorandum, U.S. Bankruptcy Judge Dennis Montali noted the lack of viable alternatives, as well as the fact that PG&E made a “convincing case for confirmation of the plan.” 

Fundraising efforts are well underway, as PCG executed a $3.5 billion private placement of common stock at $10.50 a share on June 8, with another $5.75 billion to come.  For context, the current market cap stands at $5.8 billion. 

On the debt side of the equation, the company this morning embarked on a sale of $2.75 billion in double-B-minus-rated 5-year term loans at a 450 basis point spread over Libor, along with $1 billion each in the identically-rated 8- and 10-year senior secured bonds at indicated yields of 5.25% and 5.5%, respectively. Brisk demand helped the company trim its projected interest costs, as the offerings attracted more than $17 billion in combined bidding interest according to Bloomberg.  That follows a six part, $8.9 billion triple-B-minus-rated first-mortgage bond offering earlier in the week.

The soon-to-reemerge PCG has its fans, as the Street currently features five “buy” ratings, six “holds” and no “sells” with an average price target of $14, or 27% above current levels.  In assigning a buy rating earlier this month, analysts at Bank of America wrote that they anticipated a “cleaner story” for the reorganized PCG.  

Clean is in the eye of the beholder.  Against a $38 billion post-bankruptcy debt load (well above the $22 billion in borrowings prior to its visit with the restructuring lawyers), the company projects so-called core earnings of $2 billion next year, on their way to $2.4 billion in 2024. 

Those appear to be sunny projections, as the company showed a $1.65 billion bottom line for 2017, the high-water mark of the past 15 years.  Since a bearish verdict in the Feb. 22, 2019 edition of Grant’s, shares have lost 42%, compared to a 7% gain (with dividends reinvested) from the Utilities Select Sector SPDR ETF over that period. 

Fundamental limitations loom large, as pre-wildfire results indicated an erosion in the business model before the Camp Fire disaster. PG&E generated $25.5 billion in operating cash flow over the five years through 2018, well short of the $31.9 billion in cumulative capital expenditures over that period, while the company paid some $4.4 billion in shareholder dividends from 2013 to 2017 using borrowed funds. 

“We have a company coming out of its second bankruptcy [and] is now undercapitalized,” San Jose Mayor Sam Liccardo summed things up to reporters yesterday. “Forgive me if I’m not optimistic for its prospects during the next couple of wildfire seasons.” 

QE progress report
This good ship QE has gone into dry-dock, for now at least.  Reserve Bank credit (i.e., the Fed’s sum total of interest-bearing assets) fell by $28 billion to $7.09 trillion, the lowest reading since May 27 and first sequential decline since February.  That said, recent exertions continue to leave their mark, as the three-month annualized growth rate stands at a husky 684%.  
Recap June 18

A third straight sideways drift for stocks left the S&P 500 holding on to a 2.5% gain for the week so far, leaving year-to-date losses at a modest 3.5%.  Long dated Treasurys enjoyed a strong rally, with 10- and 30-year yields falling to 0.7% and 1.47%, respectively.  WTI crude rose to near $39 a barrel, gold remained stuck near $1,725 an ounce for a sixth straight session, and the VIX fell to 32.5 to retrace roughly half of last Thursday’s 45% spike during the 6% market selloff. 

- Philip Grant

06.17.2020
Capitol ideas
Yesterday's semi-annual Congressional appearance by Fed chair Jerome Powell was a memorable one.

Yesterday’s semi-annual Congressional appearance by Fed chairman Jerome Powell was a memorable one. The central banker provided no shortage of quotable comments in explaining the recent myriad of expanded monetary exertions, which have included the upsizing of Reserve Bank credit (meaning the sum total of interest bearing assets on the Fed’s balance sheet) at an annualized pace of 726% over the past three months.  Let’s review the current state of play. 

Near-zero interest rates are, of course, a fundamental component of the chairman’s economic medicine, “until we are confident that the economy has weathered recent events and is on track to achieving our maximum-employment and price stability goals.”  In other words, the Fed is “not even thinking about thinking about raising rates.” 

Abundant purchases of Treasury debt and mortgage-backed securities are another pillar of 2008-era monetary policy dusted off for another go, as Powell promised the Fed will increase its holdings at “at least the current pace” in the coming months. 

Those purchases have helped the market digest Uncle Sam’s mammoth financing needs, which have included $2.6 trillion in fresh borrowings over the three months ended June 11.  For comparison, federal debt remained largely unchanged from mid-March to mid-June of last year. The Fed’s portfolio of Treasurys has risen by $1.62 trillion from March 11 through June 11, accounting for 63% of the net debt expansion over that period (updated figures will be published tomorrow). 

Asked about so-called yield curve control, the chairman revealed that the Fed discussed the strategy at a recent meeting of the Board of Governors:  "We briefed people up on the history of it and how it works, so people understand the technology. . . The concept of using yield curve control at the Fed is at an early stage."

Perhaps unsurprisingly, Monday’s announcement that the Fed is set to begin outright corporate bond purchases took center stage in yesterday’s testimony, as such a program is uncharted territory for the 107 year-old institution. 

That move to buy corporate bonds, the former Carlyle Group partner said, was made “out of an excess of caution” in order to maintain functioning markets.  “I don’t see us wanting to run through the bond market like an elephant snuffing out price signals and things like that,” Powell assured Congress. While the epic snap-back in credit spreads seemingly mitigated the need for such direct support, market credibility was front of mind for the chairman: “We feel we need to follow through and do what we said we would do.” 

The corporate credit markets have been counting on it.  According to S&P’s LCD unit, the first 12 days of June have featured fresh junk bond issuance of $24 billion, the second-heaviest monthly pace on record.  Year-to-date supply of domestic high-yield debt stands at $181 billion, or 61% ahead of this time last year, while $1.1 trillion in new investment-grade supply stands 73% above that of 2019. 

Not that balance sheets were too conservative before COVID-19 barged onto the scene. According to data from CreditSights, corporate liabilities stood near a record-high 135% of GDP as the calendar turned to 2020, up from 105% in 2007. 

Despite the extraordinarily EZ-monetary policy, Powell indicated little concern over an awakening of the sleeping inflation giant: 

There’s [been] downward pressure on inflation around the world for a couple of decades. And so, what the models would have called for with big deficits, they would have called for higher inflation, would have called for higher interest rates. We don’t see either of those things. So, I think we’re not working under the hypothesis that higher inflation is a likely outcome. 

While that view may enjoy plenty of support at the Fed and other central banks, a pair of establishment economists beg to differ. A March 27 essay from Charles Goodhart, emeritus professor at the London School of Economics and a former external member of the Bank of England’s Monetary Policy Committee, and Manoj Pradhan, founder of Talking Heads Macro and former economist at Morgan Stanley, makes the dissenting case:

Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate. The excessive debt amongst non-financial corporates and governments will get inflated away. The negative real interest rates that may well be necessary to equilibrate the system, as real growth slows in the face of a reversal of globalization and falling working populations, will happen. 

Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile. And if they try to raise interest rates in such a context, they will face political ire to a point that might threaten their “independence.” Only when indebtedness has been restored to viable levels can an assault on inflation be mounted.

Perhaps a topic to be revisited in the future. 

Recap June 17

A late downtick left the S&P 500 slightly below unchanged, the first red showing since last Thursday’s 6% swan-dive. Treasurys caught a bid across the curve, headlined by a strong 20-year note auction this afternoon.  WTI crude fell back below $38 a barrel, gold remained rangebound with a close near $1,729 an ounce and the VIX finished at 33.5.  

- Philip Grant

06.16.2020
Shelter some place
The recovery in housing is underway,

The recovery in housing is underway, if results from the largest homebuilder in the U.S. are any indication.  Yesterday afternoon, Lennar Corp. (LEN on the NYSE) reported that net orders for the quarter-ended May 31 fell 10.4%, far better than the consensus estimate of 23%.  

In addition, Lennar reissued full-year guidance anticipating 50,750 deliveries using the midpoint of the provided range (they had withdrawn that estimate in March), slightly topping analyst expectations of 50,580 deliveries. Management reported that new orders rose 7% in May from their prior year levels, while cancellations dropped to 18% from 23% in April.  Too, the increase in sales was “generally achieved while raising prices and reducing incentives throughout the month of May,” CEO Rick Beckwitt noted on the call. 

Early reports on the new quarter are positive.“Business rebounded significantly in May ... and this rebound has continued into the first two weeks of June,” executive chairman Stuart Miller reported.  Shareholders in Lennar have certainly enjoyed the reversal, as LEN has nearly doubled since a bullish update in the April 3 edition of Grant’s.  

Indeed, the conditions for a low-end housing renaissance were already in place as the bug hit, as household debt fell to 65% of GDP from 87% at the peak of the 2007 to 2009 cycle.  Broad price trends had also entered more sustainable territory, with the Case-Shiller 20-City Composite Index rising 2.5% year-over-year for the 14 months through February, half of the post-2000 rate. Demographics figure prominently, as millennials, the largest age cohort, are entering prime first-time homebuying ages. Thanks to housing’s central role in the financial crisis, the post-2009 era has been  characterized by underbuilt homes relative to population growth.

Also central to the Lennar bull case: Learning its lesson from the 2007 to 2009 housing bust, the company changed course by acquiring new lots via option instead of outright purchase, thus offloading land value risk while bolstering margins and enhancing cash flow. 

On the call yesterday, management announced that 32% of land values are now owned through option, up from 25% a year ago, while inventories correspondingly fell to 3.9 years from 4.5 years supply as of the second quarter in 2019. The balance sheet includes some $6.1 billion in net debt, or about 2.3 times adjusted Ebitda over the past 12 months. The shares trade at just under 11 times trailing earnings, compared to 14 times for the S&P Homebuilders Index.  

More broadly, the pandemic and lockdown have perhaps merely delayed a renaissance in the housing market as the unhappy memories of the bubble and crash fade. “I’m quite sure about where we end up, with relatively robust housing conditions particularly at the affordable end.” Marvin Shapiro, CEO of Avanti Properties Group and long-term housing bull, told Grant’s in the chaotic days of early spring.  “What I don’t know is how long a pause we are going to take.”

Sentiment, at least, points to a swift rebound in overall conditions. Yesterday, the National Association of Home Builders reported that its monthly confidence index jumped to 58 for May (readings of 50 and above signify growing confidence) from 37 in April, which was its lowest since June 2012. 

The sell-side is likewise increasingly confident. In raising their projections for homebuilder earnings through the rest of 2020 and 2021 last Thursday, analysts at J.P. Morgan cited a trio of factors, including motivated buyers thanks to lockdown-inspired cabin fever, low interest rates and tightening inventory, as the supply of single-family existing homes for sale fell 19% in April year-over-year, compared to an 11% drop in March. 

“In contrast with the 2008 great recession, housing has the potential to play hero, not villain, this time around,” declared Javier Vivas, director of economic research at Realtor.com, last week. 

Recap June 16

Another strong rally in stocks pushed the S&P 500 back within 8% of its mid-February highs, while the Treasury curve steepened notably to push the 2- vs. 30-year spread to 134 basis points, near a two-year high.  WTI crude rose above $38 a barrel, gold ticked higher to $1,727 an ounce, and the VIX held near 34. 

- Philip Grant

06.15.2020
Brave new world
One giant leap for central banks.

One giant leap for central banks.  This afternoon, the Fed announced it will commence individual corporate bond purchases tomorrow, under the Primary and Secondary Market Corporate Credit Facilities unveiled on March 23. 

In the frequently asked questions addendum to the announcement, the Federal Reserve Bank of New York noted it will “not purchase bonds of issuers that have filed for bankruptcy protection or bonds of issuers that no longer meet the facility’s minimum rating or other requirements.”

In other words, Robin Hooders, Hertz is all yours. 

 

Migratory flock
Dialing up a Hail Mary.

Dialing up a Hail Mary.  The $400 billion California Public Employees' Retirement System (CalPERS),  the nation’s largest, announced it will enhance leverage and boost allocations to private equity managers in an attempt to goose returns.  “Given the current low-yield environment, there are only a few asset classes with a long-term expected return clearing the 7% hurdle,” chief investment officer Ben Meng told the fund’s board of directors today. “Private assets clearly stand out. Leverage will increase the volatility of returns but Calpers can tolerate this.”

“We will have to live with the possibility of market drawdowns as the price for increasing the probability of achieving our ambitious rate of return,” Meng continued. “There is no alternative.” 

The status quo is lacking, to be sure. The fund lost 4% in the nine months through March, while an internal study conducted last year placed the odds of achieving that 7% annual return over the next decade at just 39%. Self-inflicted wounds compound that daunting challenge as CalPERS opted to unwind tail-risk hedging strategies in January, a move which cost the fund an estimated $1 billion payout when markets went into spin cycle two months later. 

***

As the pension fund bellwether looks to ratchet up its risk profile, private equity basks in the glow of both flush fundraising (a record $361 billion last year) and increasingly friendly treatment from regulators. 

On June 4, the Department of Labor issued guidelines stating that private equity is an appropriate investment for retirement plans such as 401(k)s, while the Securities and Exchange Commission last year advocated relaxing the rules limiting p.e. to so-called accredited investors (those with at least $1 million in assets or $200,000 in annual income), in order to  “expand investment opportunities while maintaining appropriate investor protections and to promote capital formation.” 

The influx of new capital shines the spotlight anew on curious performance discrepancies.  For instance, the largest U.S. p.e. operators reported an average 15.8% drawdown in their buyout portfolios in the first quarter, while single-B-rated companies in the S&P 500  (which generally represents the upper end of the credit ratings spectrum for p.e.-backed portfolio companies) fell by roughly 50%. 

Then, too, the proliferation of so-called friendly adjustments such as earnings add-backs, or credit for hypothetical future cost savings, figure prominently in the p.e. miracle. According to the Coller Capital Global Private Equity Barometer survey of 107 investors released today, 67% of respondents said they were “very concerned” about the quality of reported Ebitda metrics.  Yet 52% of limited partners who participated in the survey say they are not inclined to ask their managers to utilize independent third party valuation sources.

Thanks to the record breaking post-2009 bull market, buoyant asset prices (before the bug bit, anyway) rendered investment bargains few and far between. According to Bain & Company’s 2020 Global Private Equity Report, 55% of U.S. buyout deals featured enterprise values in excess of 11 times Ebitda.  For comparison, only about 20% of such transactions carried an EV/Ebitda ratio above 11 in 2007.   With rising price tags come more aggressive capital structures. Bain reports that nearly 75% of buyout deals last year featured net debt in excess of six times (reported) Ebitda, up from about 60% in 2007.  Adjusted for add-backs, those leverage figures are likely higher still. 

Yet those advantages have not translated into observed excess return. Data compiled by Ludovic Phalippou, professor of finance at Oxford Said Business School, show that p.e. has generated annualized returns of roughly 11% from 2006 to 2015 after accounting for fees, broadly matching that of the broad stock market.   

Investors may not be coming out ahead, but that’s not to say there are no winners from the great p.e. migration. “This wealth transfer from several hundred million pension scheme members to a few thousand people working in private equity might be one of the largest in the history of modern finance,” Phalippou tells the Financial Times.

For more on the great private equity migration, along with the bear case on a key cog in the p.e. machine, see the May 29 edition of Grant’s.  

Recap June 15

A rip-roaring rebound in stocks helped S&P 500 futures erase overnight losses of more than 3%, as the broad index finished nearly 1% higher by the end of cash trading.  Treasury yields finished little changed, but implied investment grade and high-yield credit spreads both tightened substantially (according to their respective CDX indices) following the Fed’s announcement this afternoon.  WTI crude rose back above $37 a barrel, gold ticked slightly lower to $1,724 an ounce, and the VIX fell 5% to 34. 

- Philip Grant

06.12.2020
Headline of the day

From Bloomberg:
              Mets Fans Beware, Private Equity-Owned Teams Lose on the Field

Probably a coincidence. 

Quack attack
Talk about feeding the ducks.

Talk about feeding the ducks. A memorable day on Wall Street saw a federal judge approve plans for bankrupt rental car agency Hertz Global Holdings, Inc. (HTZ on the NYSE, for now) to unload up to $1 billion in an at-the-market equity offering from an existing shelf-registered facility, to be managed by investment bank Jefferies LLC. That move will partially capitalize on the remarkable 10-fold rise in HTZ shares in the nine trading days since the company filed for Chapter 11 on May 26. 

While a subsequent pullback left shares at roughly four times that May 26 price, news of the proposal stirred up the hearty Hertz bulls once more. After jumping by as much as 70% in the pre-market, HTZ shares finished up by 37% (before tumbling 6% in after-market reaction to news of the approval), while trading volumes of 268 million shares were 15 times the one-year average turnover.  

“This is what I love about bankruptcy – never a dull moment.” Melanie Cyganowski, partner at law firm Otterbourg P.C. and a former chief judge in the Eastern District of New York, told Bloomberg. 

In its petition to the U.S. Bankruptcy Court in Delaware filed yesterday, the company argued: “The recent market prices of and the trading volumes in Hertz common stock could potentially present a unique opportunity for the Debtors to raise capital on terms that are far superior to any debtor-in-possession financing.”  

No buyer will be able to say the company didn’t warn them: “The common stock could ultimately be worthless,” the prospectus is expected to say. 

Time is of the essence, as the filing makes clear: “The Debtors bring this motion on an emergency basis given the volatile state of trading in Hertz’s stock and to ensure that the Debtors are in a position to capture the potential value of Hertz’s unissued shares.” 

According to data from Robintrack.net, 166,000 accounts on the Robin Hood trading platform held Hertz shares as of this afternoon.  That’s up from less than 2,000 users three months ago and 44,000 Robinhooders on May 26, the day that Hertz filed. 

While the retail masses assemble, the more routine trappings of court-administered debt restructuring proceed apace.  The New York Stock Exchange sent a delisting notice to Hertz on Wednesday, a measure which the company has appealed. The senior unsecured, 6% notes due 2028 last changed hands at 40.5 cents on the dollar (though up from 15 cents on May 26) for a yield-to-worst of 22.65%, implying that the common stock is worthless. Yesterday, Hertz filed a motion to wiggle out of lease commitments on 144,000 vehicles, claiming that it cannot afford to pay them.  

A good omen (for the stock sellers, that is) preceded today’s legal victory. This morning the Securities and Exchange Commission approved a registration statement by The United States Oil Fund, LP (USO is the ticker) to issue one million additional shares, continuing the expansion in the float to a current 185 million shares from less than 30 million shares in early March.  Shares in USO are down 74% year-to-date, double the decline in front-month WTI crude over that period, while both the Commodity Futures Trading Commission and the SEC are investigating the fund’s risk disclosures, according to Bloomberg. 

A call-to-action CNBC headline today: “No money? No expertise? Ditch your excuses and start investing anyway” 

Hertz’s creditors, among others, are counting on it. 

Recap June 12

A modest rebound for stocks, as the S&P 500 finished 1% higher, near the midpoint of its intraday range, to narrow the weekly loss to 4.8%.  Some weakness in long-dated Treasurys pushed the curve steeper, as the 10- and 30-year yields rose to 0.71% and 1.46%, respectively.  Gold and WTI crude oil both edged higher, finishing at $1,731 an ounce and $36.5 a barrel, and the VIX fell to 36, down 11% today but up 47% for the week. 

- Philip Grant

06.11.2020
Mr. Congeniality
Here’s Commander-in-Chief Donald Trump on Twitter this morning:
 
The Federal Reserve is wrong so often. I see the numbers also, and do MUCH better than they do. We will have a very good Third Quarter, a great Fourth Quarter, and one of our best ever years in 2021. We will also soon have a Vaccine & Therapeutics/Cure. That’s my opinion. WATCH!
 
Also today, White House economic advisor Larry Kudlow offered his own critique on Fox News: 
 
I do think Mr. Powell could lighten up a little when he has these press offerings. You know, a smile now and then, a little bit of optimism, OK? I'll talk with him, and we'll have some media training at some point.
Double vision
A decimation wasn't enough.
A decimation wasn’t enough.  The Financial Times reported Tuesday that the Vision Fund, SoftBank Group Corp’s in-house venture capital operation, will cut some 15% of its workforce.  That’s up from reports pegging layoffs at 10% of staff as of late May, and follows the disclosure of a $17.7 billion net loss in the 12 months through March 31.  Not everyone at the Vision Fund has reason to feel glum, as CEO Rajeev Misra is set to take home a $15 million pay package this year, more than double the $7 million in compensation for 2019. 
 
As the Vision Fund flounders, SoftBank and its charismatic CEO Masayoshi Son attempt to steer a new course, announcing plans to divest some $42 billion in assets to finance stock buybacks and bolster corporate liquidity. Those planned sales potentially include a portion of its crown-jewel stake in Chinese retail giant Alibaba, Inc.  In addition, SoftBank reduced its stake in cash-generating Japanese telecom subsidiary SoftBank Corp. to 61.5% from 66.5%, according to a May 22 filing.
 
Investors have largely cheered Son’s latest maneuvers, as shares have nearly doubled from their March lows and now sit 18% higher from an initial bearish salvo in the Dec. 15, 2017 edition of Grant’s
 
Markets may make opinions, but dissenting voices remain. A report today from S&P Global Ratings cautions: “We have questions on the company's intention to adhere to financial management that prioritizes financial soundness and creditworthiness.”
 
As do we. 
Benches clear
"Brawls erupt in U.S. Debt Markets After Borrowers Get Desperate,"
“Brawls Erupt in U.S. Debt Markets After Borrowers Get Desperate,” blares a headline from Bloomberg this morning.  The upshot: a raft of disputes have broken out between distressed companies and their increasingly nervous lenders, as a wave of largely p.e.-backed borrowers “are seeking to take advantage of years of weakening creditor protections to help cut obligations and raise cash after the coronavirus outbreak brought businesses to a standstill.” 
 
In particular, issuers including Sinclair Broadcast Group, Inc., SM Energy Co. and Revlon, Inc. have attempted to shunt assets out of their creditors’ reach or impose principal haircuts through debt exchanges, leading to contentious or outright hostile negotiations with their scorned lenders.  “Anyone professing to be shocked by it probably hasn’t been around very long,” observed Philip Brendel, senior credit analyst at Bloomberg Intelligence.  
 
Indeed, as leveraged loans proliferated during this cycle (growing at a 10.2% compound annual rate from 2010 to 2019, compared to 3.7% for junk bonds), the share of those loans designated as covenant-light (meaning few or no legal protections if the borrower runs into trouble) exceeded 80% at the end of April according to LCD. That’s up from 17% in 2007. 
 
“Rates were suppressed long after they should have been; it drove yield hunger and a non-bank explosion that created misalignments,” Daniel Zwirn, chief investment officer at Arena Investors, commented to Bloomberg. “Now they’re learning once again, there are consequences. We are at just the beginning of this thing. They’re going to fight like dogs to avoid those consequences.” 
 
The roster of potential battlefields continues to grow. Last Thursday, S&P Global reported that the downgrade-to-upgrade ratio for leveraged loans reached 43 to 1 on a trailing three-month basis, up from 3.8 times in February and 8.7 to 1 at the peak of the 2007 to 2009 financial crisis.   
 
Those downgrades have resulted in an increasingly bottom-heavy ratings profile, as roughly 11% of the domestic leveraged loan market is now rated triple-C and below, up from just 2.7% five years ago and approaching the 2009 peak of 11.5%.  There’s plenty more where that came from, as analysts at UBS believe that even in the most optimistic scenario (including a return to near-normal levels of economic activity by the end of June) those triple-C-rated ranks will swell to 33% of the market. 
 
Needless to say, the combination of rising corporate distress and proliferation of forgiving legal structures suggests that creditors may find more trouble than they bargained for during this default cycle.  A May 20 analysis from Moody’s Investors Service forecasts that recoveries on first-lien term loans will fall to 58% for p.e.-sponsored companies and 62% for non-p.e.-backed ones, far below the realized historical recovery averages of 75% and 78%, respectively.
 
For an early look at what some unhappy creditors are now contending with, see the analysis headlined “Tomorrow’s debt hearings” in the July 13, 2018 edition of Grant’s
QE progress report
A further easing off the throttle, as Reserve Bank credit (the sum total of interest-bearing assets at the Fed) rose to $7.113 trillion, up a relatively modest $12 billion from last week’s reading.  That compares to a $41 billion sequential increase last week and $138 billion uptick for the week ended May 27 but was enough to push the three-month annualized growth rate to 726%. 
Recap June 11
A painful reckoning for stock market Johnny-come-latelies, as the S&P 500 absorbed a near-6% decline led by the energy, financials and materials sectors, to leave the broad index at its lowest close since May 26.  The Treasury curve flattened aggressively, with the two-year yield rising 3 basis points to 0.2% while the 30-year long bond fell 11 basis points to 1.4%.  WTI crude was clubbed by nearly 10% to below $36 a barrel, gold edged lower to $1,729 an ounce, and the VIX rose to near 41, up a cool 48% on the day. 
 
- Philip Grant
06.09.2020
Headline of the day
From CNBC:
 
The hot new thing to make your stock pop:  Go bankrupt
 
The article, which was published shortly after the market open, mentions six bankrupt or near-bankrupt names which have recently enjoyed outsize percentage gains.  Each of the six finished well off its intraday high, with declines ranging from 13% from Pier 1 Imports Inc. to 66% from Chesapeake Energy Corp.
 
Bankruptcy’s bearish? 
Night court
The European Central Bank announced last week
The European Central Bank announced last week it will upsize its Pandemic Emergency Purchase Program by €600 billion ($680 billion) to a total sum of €1.35 trillion and extend the program until June 2021 from a prior conclusion at year-end.  
 
“With these decisions, the ECB clearly surprised the markets on the dovish side” concluded Andreas Billmeier, sovereign research analyst at Western Asset Management.  Investors seemed to agree: German, Italian and French equity markets each rose by more than 10% last week, while the spread between German and Italian bond yields reached their tightest since March.
 
Deflation fears figure prominently in that escalated policy response.  Bank of Finland governor Olli Rhen described the odds of unwelcome price-level decline as “elevated,” while Pablo Hernandez de Cos, governor of the Bank of Spain, commented that “when there is the risk of low inflation or even deflation, the monetary policy response has to be even more forceful and even faster.”  
 
Financial markets are also front-of-mind for the ECB, and the swift rebound in asset prices has not been lost on the monetary mandarins.  In an interview with Bloomberg on Friday, Hernández de Cos declared that pandemic-related volatility “is still present but it has more or less stabilized, precisely as a result of this program.”   
 
Then, too, so-called capital key requirements, which stipulate that ECB purchases of sovereign debt are to be undertaken only in proportion to the size of the issuer’s economy, are apparently no impediment. In an interview with Bloomberg last week, Hernández de Cos declared that “the capital key is a benchmark that’s there but it’s not a constraint in the short run. . . we are going to continue exercising the full flexibility of the program without considering the capital key as a restriction.” 
 
Indeed, between March and May, the ECB allocated 20% of its public-sector purchase program to Italian assets, above the 13.8% quota determined by that capital key metric.  
 
Those stepped-up purchases are a boon to fiscally frail Italy, which will see its sovereign debt load reach a record 1.59 times GDP this year according to projections from Bloomberg.  Yet with projected issuance of €160 billion of net debt this year (more than triple last year’s new supply), lower borrowing costs will keep interest expense roughly unchanged from 2019 according to Chiara Cremonesi, fixed income strategist at UniCredit SpA. “In the short to medium term, there is no debt sustainability issue,” Carsten Brzeski, chief economist for the eurozone at ING, concludes.
 
Political and legal sustainability may be another matter. On May 5, Germany’s Constitutional Court ordered the ECB to conduct a so-called proportionality assessment, designed to determine whether “economic and fiscal policy [side] effects” of large-scale asset purchases outweigh the ECB’s mandated policy objectives. 
In brushing aside a pro-ECB ruling from the European Court of Justice in 2018, the court gave the central bank three months to explain its case, on the pain of potentially barring Germany’s Bundesbank from participating in the purchase program and even forcing the central bank to sell its €500 billion sovereign bond portfolio.  
 
In testimony to European parliament yesterday, ECB president Christine Lagarde went on a charm offensive, stating that the central bank “will provide any support and assistance that can be helpful” in the response to the court.  Lagarde also attempted to assuage the German judiciary’s concerns, arguing that “our crisis-era measures are temporary, targeted and proportionate. . . to the severe risks to our mandate that we are facing.”
 
Yet while Lagarde looks to mollify skeptics in Europe’s largest economy, a colleague is already thinking about the next frontier for radical action.  Asked about the potential for direct equity purchases in an interview Sunday with the Die Presse, Robert Holzmann, head of Austria’s central bank and a member of the ECB Governing Council replied: “Never say never. If the need is there, this discussion will definitely have to take place.”
Recap June 9
Stocks absorbed a modest selloff, with the S&P 500 finishing in the red for only the third time in the last 12 tries as the broad index remains near unchanged year-to-date. WTI crude and gold both caught bids to finish near $39 a barrel and at $1,715 an ounce, as the Dollar Index fell to three-month lows.  
 
Risk aversion was in force elsewhere, as Treasury yields darted lower across the curve with the 2-, 10- and 30-year yields finishing at 0.2%, 0.82% and 1.57%, respectively, while the VIX rose above 27.5 to extend its two-day rally to more than 12%. 
 
- Philip Grant
06.08.2020
Meal worm
Let the games begin.
Let the games begin.  CNBC reports that merger talks between Grubhub, Inc. (GRUB on the NYSE) and Uber Technologies, Inc.’s Uber Eats division have hit a snag, with Uber reportedly balking at Grubhub’s request for antitrust concessions.  On May 20, a quartet of senators sent a letter to the Department of Justice and Federal Trade Commission vowing to “closely monitor the negotiations” between the companies and expressing concern that “serious competition issues” would arise from the proposed combination. 
 
Conveniently for Grubhub’s negotiating position, foreign suitors are apparently kicking the tires as well.  CNBC also reported on Friday that Europe’s Delivery Hero S.E. and Just Eat plc. have both expressed interest in acquiring GRUB.  
 
Data suggesting that the pandemic and lockdown have been no panacea for the delivery industry perhaps explain the push for consolidation.  Although meal delivery service volume for April nearly doubled relative to a year ago according to research firm Second Measure, Grubhub guided second quarter adjusted Ebitda to $5 million, well below the consensus estimate of $27 million, on account of increased marketing and other investment spending (“this is a completely discretionary short-term business decision designed to support our industry,” the press release declared). Additionally, GRUB withdrew its revenue and Ebitda guidance for 2020.  
 
With Mr. Market in a forgiving mood these days and the M&A story now front-and-center, GRUB shares are up 42% since that update, narrowing their decline to 5.5% since a bearish analysis in the Sept. 20 edition of Grant’s
 
As the food-delivery businesses is a commoditized one, industry entrants primarily compete on price. Grubhub rolled out $10 discounts on orders of $30 or more placed in the evening during the month of April, while three weeks later rival platform Postmates ran promotions promising unlimited free delivery for three months for new signups.  
 
External forces are also weighing on the Grubhub model. Two weeks ago, New York City Mayor Bill de Blasio signed a bill temporarily capping delivery fees at 20% of the order, cutting into the normally 30% per-order commission rate that Grubhub had previously charged participating restaurants. Other cities including San Francisco, Washington D.C. and Seattle established maximum commission rates of 15%, while the chairman of the finance committee in Chicago’s city council has introduced an ordinance capping fees at just 5%.  
 
Wider and more stringent fee caps are not the only potential regulatory pitfall. A broader implementation of California’s Assembly Bill 5, which would oblige so-called gig economy companies to classify their workers as employees instead of independent contractors (thus putting the employers on the hook for healthcare expenses along with Social Security and Medicare taxes), stands as a further risk for Grubhub and fellow "gig economy" concerns.
 
Increased government attention carries further potential complications. Bloomberg reported Friday that the recent boom in online restaurant ordering could leave Grubhub and its peers as attractive targets for the tax man, as municipalities look for additional revenues to help plug gaping budget holes. “The larger food delivery services are going to get audited – if they haven’t been already – in pretty much every jurisdiction because they’re big enough,” Michael Feiszli, managing director at BDO LLP, told Bloomberg. “They are obviously one of the businesses thriving during this pandemic and that will make them a target in most jurisdictions over the next three or four years.” For its part, Grubhub noted in its most recent form 10-Q that “the company is currently under examination by the Internal Revenue Service for its federal income tax return for the tax year ended December 31, 2017.” 
 
The bulls aren’t worried, as GRUB’s enterprise value is equal to 58 times adjusted Ebitda over the 12 months through March 31, compared to a 15 times EV-to-Ebitda ratio for the S&P Restaurants Index. 
 
Investors assigning GRUB a generous valuation may want to consider the opinion of one knowledgeable observer.  In a letter to shareholders last fall, GRUB CEO Matt Maloney lamented: “We believe the easy wins in our industry are now a lot harder to find.”
Recap June 8
Another day of euphoric action included a 1.2% rise in the S&P 500, as the broad index finished at its best levels of the day and completed its climb back into the green year-to-date. Treasurys caught a bid with the 10- and 30-year yields falling to 0.87% and 1.64%, respectively, while gold bounced back to near $1,700 an ounce and WTI crude pulled back to $38 a barrel.  The VIX rose by 5% to near 26, its best percentage gain since May 21. 
    
- Philip Grant
06.05.2020
Debits field
Ye’re out – of investment grade.
Ye’re out – of investment grade. Yesterday, Standard & Poor’s downgraded the credit rating of Citi Field, home of the New York Mets, to double-B-plus from triple-B-minus. 
 
Projecting an 85% decline in game-day revenue this year (a figure which could be 100% if the negotiating impasse between owners and the players association continues much longer), the rating agency is now looking askance at the National League club's $700 million in municipal debt.  Mets ownership, S&P believes, may be obliged to tap its $66 million debt service reserve fund to help meet a $22 million interest payment due in December. 
 
Taking a loss without playing a game:  How very Mets-like. 
Friday news dump
This morning's head-scratcher of a May jobs report,
This morning’s head-scratcher of a May jobs report, which included a net 2.5 million increase in payrolls and 13.3% unemployment rate according to the Bureau of Labor Statistics (just slightly better than the consensus estimates of 8.3 million jobs lost and a 19.5% unemployment rate, respectively) is merely the latest surreal development in what is already a year that won’t be easily forgotten.  There are others:
 
Shares in Hertz Global Holdings, Inc. traded as high as $3.70 this morning, good for a 351% rally from Wednesday’s closing price.  The only problem: The company filed for bankruptcy two weeks ago. 
 
Bloomberg gently spells it out for the novices: “Shareholders rarely recover anything from companies that have filed for Chapter 11 because under U.S. Bankruptcy Code, all of a company’s debts must be repaid in full before stockholders receive anything.”  Hertz carries some $19 billion in net debt, while the rental-car agency generated $4.4 billion in adjusted Ebitda last year.  The company’s senior unsecured 6% notes due 2028, which were issued last fall, currently trade at 29 cents on the dollar for a yield-to-worst of 30%. 
 
Other types of restructuring situations have also caught Mr. Market’s eye, as shares in department store giant Macy’s, Inc. rose to their best finish since March 11. The stock has rallied 37% in the four trading days since looters trashed its flagship outlet on West 34th Street in Manhattan.   While the arrival of corporate raiders has long been a positive catalyst for publicly traded companies, it turns out that actual raiders can be bullish too. 
 
Yesterday, the Nasdaq Stock Exchange sent a Tweet urging readers to “explore options [trading] strategies.”  A trio of suggestions from the exchange:  bull put spreads, along with the so-called iron condor and iron butterfly strategies, each of which entails purchasing four separate options contracts. 
 
Evidently, that public education campaign is bearing fruit, as data from the CBOE show that call volume reached 2.3 million contracts yesterday, the highest one-day total since 2011.  Then again, the concept of hedging appears to be less popular, as the put-to-call ratio registered at 0.4 on Wednesday, the lowest reading since 2014. 
 
Perhaps no one sector better captures the current zeitgeist than the airlines. Largely grounded since the pandemic, the industry has ridden the Wall Street wave to hefty recent gains (for instance, American Airlines Group, Inc. shares rose a cool 76% this week). The proximate cause: a wave of speculative interest which helped the U.S. Global Jets ETF post 64 straight days of inflows, pushing the fund’s assets above $1 billion from $33 million in early March.  Over the same period, the number of accounts at millennial-friendly trading venue Robinhood holding JETS shares jumped to near 30,000 from 500, according to data from website Robintrack.net. 
 
Of course, that move caught some experienced investors by surprise, most notably Warren Buffett. This morning, President Trump couldn’t help but take a swipe at the Oracle of Omaha, commenting on Berkshire Hathaway’s early May sale of its stakes in four major U.S. carriers: 
 
Warren Buffett sold airlines a little while ago. He’s been right his whole life, but sometimes even someone like Warren Buffett — I have a lot of respect for him — they make mistakes.  They should have kept the airline stocks because the airline stocks went through the roof today.
 
And don't get him started on Gen. Mattis.
Recap June 5
Stocks finished slightly off session highs, though the 2.4% rip in the S&P 500 was enough to push the broad index to within 6% of its February highs and narrow year-to-date losses to less than 2%.  Another round of selling pressure in Treasurys largely abated this afternoon, leaving the 10- and 30-year yields at 0.88% and 1.66%, respectively.  WTI crude closed above $39 a barrel for the first time since early March, while gold slumped to $1,683 an ounce and the VIX fell to 24, 22% below Monday’s highs. 
 
- Philip Grant
06.04.2020
Shark bites
A gift for the people.
A gift for the people.  Yesterday, the Department of Labor issued guidelines stating that private equity is an appropriate investment for retirement plans such as 401Ks.  Labor Secretary Eugene Scalia told reporters that the guidance “helps level the playing field for ordinary investors and is another step by the department to ensure that ordinary people investing for retirement have the opportunities they need.”
 
The DoL has company in that view. While current rules restrict p.e. to so-called accredited investors (those with $1 million in assets or $200,000 in annual income), the Securities and Exchange Commission last year suggested relaxing those rules in order to  “expand investment opportunities while maintaining appropriate investor protections and to promote capital formation.” 
 
The highly illiquid nature of private equity portfolios and discretionary price marks figure prominently in p.e’s appeal. In the first quarter, the buyout portfolios of industry heavyweights KKR & Co., Inc., The Blackstone Group, Inc., Apollo Global Management, Inc. and the Carlyle Group, Inc. were down an average of 15.8%.  By comparison, publicly traded single-B-rated companies (usually the highest credit rating of p.e.-backed companies) in the S&P 500 absorbed losses closer to 50%.  
 
While regulators look to open the p.e. door to Joe and Jane Six-Pack, the downside of illiquidity is on display.  Institutional Investor reports today that the S.E.C. “is looking into” valuation problems in the bond market during the March asset-price swoon, as difficulty in ascertaining the true clearing value of  rarely-traded debt securities led certain credit-themed hedge funds to suspend redemptions. 
 
       ***
 
Leveraged loans (i.e., floating-rate, tradable bank debt issued by speculative-grade borrowers), figure prominently in the private equity playbook, as p.e.-backed companies account for over 60% of the loan market according to estimates from S&P’s LCD unit.  The asset class thrived in the post financial crisis epoch, growing at a 10.2% compound annual rate in the nine years through December, compared to 3.7% growth for junk bonds. Last week, a New York judge dismissed an investor lawsuit claiming that a loan syndicated by J.P. Morgan Chase & Co. should be officially designated as “securities,” and subject to the same disclosure rules as stocks and bonds.  
 
In issuing his opinion, Federal District Judge Paul G. Gardephe cited the presumptively informed loan market investor: “It would have been reasonable for these sophisticated institutional buyers to believe that they were lending money, with all of the risks that may entail, and without the disclosure and other protections associated with the issuance of securities.”  Currently, the S&P/LSTA Leveraged Loan Price Index trades at 90 cents on the dollar, up from the March lows of 76 cents, but well off the recent highs of 97.3 in January, prior to the pandemic and lockdown.
 
Collateralized loan obligations, or packaged and securitized collections of leveraged loans, present their own potential for broader complication.   On Tuesday, the Bank of Japan and the Japanese Financial Services Agency regulator warned that local institutions should pay heed to risks within CLOs, which account for roughly half of the leveraged loan universe.  With banks and investors in Japan forced to reach for yield, CLOs have become investment de rigueur:  Japan’s five largest banks held a combined $126 billion in CLOs as of March 31, largely concentrated at the triple-A level.  
 
Trouble is afoot down the CLO credit spectrum.  Yesterday, Moody’s added 241 CLO securities to its watchlist for potential downgrade, joining 859 such tranches which have been under review since April.  Together, the watch-listed securities now account for roughly 25% of all outstanding CLO notes, and, while none of those tranches is rated triple-A, eight are rated double-A and 51 are rated at single-A. 
 
Risks in the underlying loans themselves are even more pronounced, if the actions of rating agencies are any guide.  Thus, the rolling three-month ratio of downgrades to upgrades within the S&P/LSTA Leveraged Loan Index reached an eye-popping 43 to 1 at the end of May, LCD reported yesterday.  Over the last 12 months, the downgrade-to-upgrade ratio stood at 8.5 times, easily topping the 5.3 times peak in 2009.
 
Come on in, mom and pop. The water’s fine. 
QE progress report
Lucky sevens:  Reserve Bank credit (or the Fed’s sum total of interest-bearing assets) rose to $7.1 trillion this week, up $42 billion from a week ago.  While down from a $137 billion sequential increase in last week’s reading, the latest move was enough to nudge the three-month annualized growth rate to 700% from 655% on May 27.  Relative to a year ago, Reserve Bank credit is up 82%. 
Recap June 4
Bear steepening action in Treasurys continues apace, as the 10- and 30-year yields jumped to 0.82% and 1.63%, respectively, with each at their highest since March.  Stocks took a pause after a feverish recent run, as the S&P 500 finished modestly in the red, while gold climbed back to $1,716 an ounce and WTI crude held at $37 a barrel.  The VIX ticked to 25.5, its third straight decline.   
 
- Philip Grant
06.03.2020
The chicken man cometh
The Department of Justice announced indictments of four current and former senior executives at chicken producers Pilgrim’s Pride Corp. (PPC on the Nasdaq), and privately-held Claxton Poultry Farms this afternoon for alleged price fixing and bid rigging from 2012 to 2017.  Shares in Pilgrim’s Pride and industry leader (by market share) Tyson Foods, Inc., fell by as much as 17% and 10%, respectively, in reaction.
 
With the poultry industry now facing a potential power vacuum, perhaps a new kingpin will emerge: 
 
Water hazard
In an interview with Bloomberg Television today,
In an interview with Bloomberg Television today, former New York Fed president William Dudley identified one downside to the central bank’s new corporate debt purchase program, which extends to both junk-bond ETFs and individual debts of sub-investment-grade concerns:
 
People who have high-yield debt that’s outstanding, a lot of times that’s happened by choice. So for the Federal Reserve to intervene and support those asset prices, is basically creating a little bit of moral hazard in the sense you’re encouraging people to take on more debt.
 
Debtors have certainly made hay in 2020, as new supply of high yield and investment grade corporate debt is up 23% and 100%, respectively, from last year’s pace. The brisk credit recovery creates its own complications.  The Wall Street Journal notes today that the Fed’s Primary and Secondary Corporate Credit Facilities, which spurred a gangbusters bond rally since the March 23 announcement, have seen little actual usage.  
 
While restrictions on the program, which include mandates that eligible companies be domiciled in the United States and have not participated in the Treasury Department’s CARES Act stimulus package, partially explain the hesitance, the price snap-back may itself be the bigger hinderance.  “I don’t really think the market needs it anymore,” Thomas Murphy, portfolio manager at Columbia Threadneedle Investments, told the Journal. [The Fed] is a victim of its own success.” 
 
Across the pond, the European Central Bank looks set to follow the Fed’s lead.  Ahead of its regularly scheduled meeting tomorrow, analysts at Bank of America anticipate the ECB will add so-called fallen angel bonds (i.e. those recently downgraded to junk from investment grade) to its repertoire of corporate asset purchases. 
 
While the ECB, which has been in the corporate bond market since 2016, prepares to widen the scope of its operations, traditional lenders spin their wheels. Bloomberg reports today that European banks have been unable to extract either better terms or more robust covenant protections to cash-hungry borrowers despite the severe economic slowdown.   
 
“It’s fair to say we have not seen the massive introduction of tighter documentation in syndicated loans across Europe as a result of the pandemic,” Reinhard Haas, head of syndicated and leveraged finance at Commerzbank A.G., told Bloomberg. 
You must be this tall to ride
Easy does it?
Easy does it?  Interest rates on auto loans continued to tumble in May, Edmunds.com announced yesterday, with an average 4% annual percentage rate across the U.S.  That’s down from 4.3% in April and 6.1% a year ago, for the lowest since 2013 and the third lowest since the firm began collecting such data in 2002.   
 
Zero-percent APR financing accounted for 24% of transactions, down slightly from 25.8% in April but still miles above the 3.6% logged in February, before the bug and lockdowns barged onto the scene. “Consumers who purchased a car in May got to take advantage of some of the best deals we’ve ever seen,” Jessica Caldwell, Edmunds’ executive director of insights commented.  “Even with 0% finance deals down slightly, more car shoppers got better financing rates than usual.”   
 
With dwindling borrowing costs come stretched loan terms, as the average new car loan was extended 71.4 months in May, up from 69.6 months a year ago and 67.9 in 2015. 
 
Those easy terms and ever-lengthening loan durations are making some would-be creditors a little nervous. Yesterday, CNBC reported that Wells Fargo, one of the largest new- and used-vehicle lenders, terminated its relationship with hundreds of independent auto dealers around the U.S.  In confirming the scoop, a Wells Fargo spokeswoman reasoned that the bank has “an obligation to review our business practices in light of the economic uncertainty presented by COVID-19.” 
 
For a detailed look at the state of the auto industry, along with an updated analysis of a longtime pick-to-not-click, see the May 15 edition of Grant’s
Recap June 3
Another rip-roaring rally pushed the S&P 500 to within 8% of its February 19 high-water mark, while the tech-heavy Nasdaq 100 came within a few basis points of setting its own fresh record high.  
 
That abundant risk appetite was on display elsewhere, as the Treasury curve saw another round of steepening as the 30-year bond yield jumped to 1.54%, its highest since March 19. Gold was hammered by nearly 2% to fall back under $1,700 an ounce and the VIX continued its descent with a close below 26. 
 
- Philip Grant
06.02.2020
Popularity contest
Last week, Popular, Inc. (BPOP on the Nasdaq),
Last week, Popular, Inc. (BPOP on the Nasdaq) announced the completion of its $500 million accelerated share repurchase program.  The prepaid buyback was supposed to run through calendar 2020 but was accelerated after BPOP shares fell below a pre-determined threshold during the pandemic-driven selloff in March. 
 
With asset prices staging a dramatic reversal, that development is now looking like a welcome one. Since a bullish analysis in the March 20 edition of Grant’s, shares have returned 49%, topping the 21% rise in the KBW Regional Banking Index. 
 
Popular, Puerto Rico’s largest bank, endured its share of tribulations well before the apocalyptical 2020, including natural disasters, government default and an exodus equal to nearly 16% of the island’s population over the past 15 years. As Paul Cardillo, head of investor relations, told Grant’s in March, “we are a bank that has lived a stress test.” 
 
Those troubles have helped form a resilient operator, as BPOP featured a common equity tier one ratio of 15.8% and a loan to deposit ratio of 60% as of March 31, both conservative figures relative to similarly-sized U.S. peers.  
 
As the bank looks equipped to ride out adversity, the timely hastening of those buybacks may further bolster the bull case.  Analysts at Piper Sandler wrote in a May 27 report that the accelerated share repurchase program lifted March 31 tangible book value per share to $58.93, some 34% above the current share price. The analysts, led by Alexander Twerdahl, conclude: “We continue to be very bullish on BPOP.” 
The Maalox chronicles
As costs related to the pandemic, lockdowns and aftermath continue to pile up,
As costs related to the pandemic, lockdowns and aftermath continue to pile up, different jurisdictions have opted for varying strategies in their efforts to pay the bills.  Let’s review. 
 
French finance minister Bruno Le Marie declared in a radio interview today that France will eschew tax increases to chip away at its debt load.  “Today we have taxation that is very heavy, among the highest of all developed economies so good sense is not to increase pressure on French people.” Instead, pro-growth policies would carry the burden.   
 
With the French government now projecting an 11% output contraction this year (compared to an estimated 8% decline in April), some are skeptical that France can pull that off. “It’s difficult to avoid the conclusion that, once again, the tax man cometh,” HSBC senior economic advisor Stephen King wrote yesterday.
 
Stateside, the poster child for municipal dysfunction looks to keep the lights on.  A report from S&P Global Ratings yesterday determined that Illinois’ fiscal 2021 budget “continues to be precariously balanced and does not include measures to meaningfully address structural instability.”   
 
Illinois’ $42.8 billion in projected spending is 5.8% above the prior year’s levels, while recurring revenues are now expected to drop $4 billion, or 10.5%, compared to estimates released in January. An outstanding $7.2 billion in backlogged bills plus unfunded pension benefits add to the Land of Lincoln’s headaches. To help plug that yawning gap, S&P expects Illinois to require $5 billion in direct federal aid or loans from the Federal Reserve’s Municipal Liquidity Facility.  
 
Finally, there’s Uncle Sam himself. Yesterday, the Congressional Budget Office estimated the lockdown-related economic toll at $7.9 trillion in lost output over the next decade, even after accounting for government stimulus and other support. That’s more than one-third of 2019 nominal GDP, which footed to $21.5 trillion. 
 
Meanwhile, Bloomberg reports that yesterday’s three- and six-month Treasury bill sales showed “signs of market indigestion,” as yields priced at their widest levels compared to overnight swaps since the middle of April, a divergence which suggests a potential increase in funding risks.  The government’s checking account at the Federal Reserve reached a record $1.45 trillion on Friday, a development which, Bloomberg notes, “reflects huge debt issuance to fund aid packages for the virus outbreak.” 
 
Somebody has to pay. 
Recap June 2
All copacetic here, as a fifth green finish for stocks in the last six tries narrowed year-to-date losses on the S&P 500 to less than 5%, while the HYG iShares High Yield ETF jumped to its best finish since March 5.  The Treasury curve steepened again, with the 30-year yield rising to 1.48% compared to 1.24% a month ago.  WTI crude rallied to near $37 a barrel, gold pulled back to $1,727 an ounce, and the VIX closed below 27 for the first time since late February. 
 
- Philip Grant
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