Devalue Investing
Signs of life for moribund European consumer prices?

Signs of life for moribund European consumer prices?   As the European Central Bank gets set for its next policy meeting on Thursday, the so-called five year, five-year forward inflation swap rate (the ECB’s preferred gauge of future inflation expectations) reached as high as 1.36% last week, up from a 72 basis point March nadir and approaching a two-year high.  The swiftness of the rebound caught some off guard.  “It is quite a remarkable move, it has surprised us,” Jorge Garayo, rates and inflation strategist at Société Générale, commented to The Wall Street Journal last week. 

That shifting psychology looks unlikely to spur much of a change in course from the ECB, which has imposed a negative 50 basis points benchmark deposit rate and grown its balance sheet to the equivalent of 43% of 2019 euro area nominal GDP (double its relative holdings five years ago and compared to 34% of nominal GDP at the Federal Reserve) in hopes of stirring inflationary forces.  

In an interview with Austria’s Der Standard last week, executive board member Isabel Schnabel warned that the “biggest economic mistake” the central bank could make would be withdrawing stimulus too soon.  Schnabel went on to argue that “only government policy can provide relief by ensuring sustainable growth and encouraging investment.” ECB president Christine Lagarde concurred: “Any kind of tightening at the moment would be very unwarranted.”

As consumer price trends remain front-and-center, both internal and external factors have Frankfurt’s attention. ECB governing council member François Villeroy de Galhau declared last Wednesday that “we remain clearly committed to our target of 2% inflation. To achieve this, we will maintain favorable monetary conditions [for] as long as necessary, and we are monitoring with particular attention the negative effects of the euro exchange rate with other currencies.”  Lagarde added that the central bank would “continue to be extremely attentive to the impact on prices that exchange rates have.”   

Indeed, gyrations in the FX market look to complicate the ECB’s search for inflation. The euro remains a near three-year high against the dollar, up about 9% from a year ago, while the Deutsche Bank trade-weighted euro index sits at 125.5, also near a three-year high. A strong domestic currency cheapens import prices, putting downward pressure on inflation. 

The Financial Times reports today that the euro’s appreciation is spooking some observers, who see that rising exchange rate as anathema to the ECB’s inflation-stoking goals.“Ordinarily, you would see low inflation cause a currency to fall,” reasoned Robin Brooks, chief economist at the Institute of International Finance. “But that’s only if markets expect the central bank to respond, and right now the ECB is not getting the memo.” 

Across the Atlantic, tomorrow’s inauguration of President-elect Joe Biden looks set to further complicate the ECB’s inflationary dreams.  In a speech to the Senate Finance Committee today, incoming Treasury Secretary Janet Yellen declared that “the value of the U.S. dollar and other currencies should be determined by markets. Markets adjust to reflect variations in economic performance and generally facilitate adjustments in the global economy.” 

Bloomberg macro strategist Cameron Crise notes that: “Conspicuous by its absence was a mention of a strong dollar policy,” something regularly espoused by Treasury Secretaries prior to the Trump era. Greg Anderson, global head of FX strategy at BMO Capital Markets, added that Yellen’s market-based dollar approach “may actually lead to a weaker USD because it could limit what [other central banks] have been doing to slow the appreciation of their currencies.” 

Salman Ahmed, global head of macro at Fidelity International, sums things up to the FT: “In currencies, it’s the relative game that matters. If the ECB wants to get the euro down, they have to outgun the Fed – there’s no other way.”   

In other words, the swaps market speaks: We’re going to need a bigger bazooka. 

Recap Jan. 19

Stocks caught a bid to kick off the holiday-shortened trading week, with the S&P 500 finishing back within 1% of its Jan. 8 high water mark, while the VIX sank 5% to 23.  Treasurys went nowhere with the 10- and 30-year yields holding at 1.09% and 1.83%, respectively, gold ticked higher to $1,838 an ounce and WTI climbed back above $53 a barrel.  

- Philip Grant

Ya Gotta Believe
How low can we go?

How low can we go?   Yesterday, the triple-C-rated component of the Bloomberg Barclays High Yield Index finished at a 6.71% yield-to-worst, the skimpiest since June 2014 and within 25 basis points of all-time lows, while the option-adjusted spread of 617 basis points over Treasurys sits well inside the year ago and 10-year average levels of around 832 basis points.  

An apparent leap of faith underpins those calm credit waters.  “[T]he U.S. high-yield market is implicitly forecasting a non-energy default rate equivalent to the lowest [ever],” Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC, noted in a Tuesday commentary for S&P’s LCD unit. To determine the market forecast, Fridson looks at the number of sub-investment bonds trading at distressed levels, i.e., with option-adjusted spreads over 1,000 basis points. 

Crowded ranks among the most speculative-grade credits mark something of a contrast with Mr. Market’s sanguine view.  According to a Dec. 1 report from S&P Global, 237 North American companies sported a triple-C rating as of Oct. 31, up from about 140 such shaky credits in late 2019.  

Default data, both observed and projected, also belie those rosy assumptions. Thus, global corporate defaults totaled 226 last year, according to S&P Global, nearly double 2019’s tally and the highest figure since the 266 in 2009 (each year since included fewer than 150 defaults, with the lone exception of 2016).  In its 2021 North American Outlook released in early December, Moody’s Investors Service forecast a baseline 10.4% peak trailing 12-month default rate in March, followed by a continuation near the current 8.3% rate throughout 2021. Under a pessimistic scenario, defaults could reach as high as 15.2% later this year, nearly double the current pace.  

Investors in less risky areas of the bond market may likewise be leaving themselves precious little room for error. This morning the Bloomberg Barclays U.S. Investment Grade Index traded to a 92 basis point spread over Treasurys, the narrowest in three years and within eight basis points of the post-financial crisis low set in early 2018.  Similarly, the index’s 1.87% yield-to-worst remains near the all-time low of 1.74% set on Jan. 4. 

Then, too, corporate America has capitalized on the ultra-low rate epoch not only by adding extra dollops of debt (gross leverage among investment grade borrowers reached a record 3.7 times Ebitda at year end, according to Bank of America) but also borrowing for longer periods, thus increasing duration, or sensitivity to changes in interest rates. 

Needless to say, that combination reflects a daunting risk vs. reward proposition for corporate creditors.  Bloomberg noted yesterday that the Sherman Ratio, (named after the inventor, DoubleLine’s deputy chief investment officer Jeffrey Sherman) which measures the amount of yield on offer for each unit of duration, reached a record low of 0.1968 on Dec. 31, down nearly half from the 0.3468 seen at the start of 2020. In other words, as Bloomberg’s Brian Chappatta put it yesterday, “investors were more susceptible to losses from a move higher in interest rates than at any time in history.”  Demonstrating that point, the I.G. index is down more than 1% in January despite ongoing spread tightening, thanks to some upward pressure on Treasury yields. 

Indeed, current day corporate bondholders are a particularly put-upon lot, contending with shareholder- (and stock price-) focused management teams, as well as a Federal Reserve determined to inflate away the value of the currency in which their claims are denominated. The April 6, 2018 edition of Grant’s Interest Rate Observer put it this way: 

Creditors are the loneliest corporate stakeholders. Management disdains them. The Fed debases them. Give them this, at least (it’s a kind of virtue, anyway): They never complain.

Recap Jan. 15

The bears enjoyed a rare upper hand as fourth quarter earnings season got underway, with the S&P losing 75 basis points to settle 1.5% lower for the week.  Treasurys were well bid, with the 10-year yield falling back to 1.1% to erase its weekly losses. The VIX jumped 5% to finish north of 24, WTI slipped 3% to $52 a barrel and gold dropped to $1,826 an ounce as the Dollar Index closed at its highest level in more than a month. 

- Philip Grant

Space Oddity
Reuters reports today that New York-based astrologer Maren Altman “has been following the movements of celestial objects

Reuters reports today that New York-based astrologer Maren Altman “has been following the movements of celestial objects to predict bitcoin price fluctuations since last summer.”  The 22-year old, who warned of a crypto correction on Jan. 11 on account of the fact that Saturn would soon cross Mercury (the price of bitcoin indeed sank by 20% soon thereafter) has amassed more than one million followers on the Tik Tok social media app.

Heavenly thinking pervades the stock market as well.  Yesterday afternoon, exchange traded fund manager ARK Invest filed paperwork with the Securities and Exchange Commission to create a “Space Exploration ETF,” which will focus on companies “leading, enabling or benefitting from technologically enabled products and/or services that occur beyond the surface of the earth.” 

Mr. Market liked the sound of that, as shares in likely constituent companies Virgin Galactic and Maxar Technologies each rallied by about 20% today following the dissemination of that news.  

In a Dec. 22 CNBC appearance, ARK founder and chief investment officer Cathie Wood argued that investors need to “get on the right side of change and stay on the right side of change because it has hit escape velocity in the aftermath of the coronavirus.” 

The investing public has taken that message to heart.  As Bloomberg senior ETF analyst Eric Balchunas notes today on Twitter, ARK’s existing suite of ETFs have attracted a whopping $4 billion of inflows in this young 2021, outpacing passive management behemoth BlackRock and equal to about 14% of all U.S. ETF flows.

Shoot for the stars. 

Private Pile
It’s a new day for leveraged loans.

It’s a new day for leveraged loans.  The S&P/LSTA Leveraged Loan Index has returned more than 1% so far in January, outpacing a negligible positive return for domestic junk bonds and a 1% loss for Treasurys, pushing the loan index north of 97 cents on the dollar, to its best levels since January 2020. 

As the market recovers (loans returned a modest 3% last year, lagging the 7% gain seen in high yield and 8% advance in Treasurys), investors look to dip their toes back in the water.  Citing data from EPFR Global Data, The Wall Street Journal notes that loan mutual funds and ETFs have attracted a net $740 million since the start of the year, placing January on pace for the first month with positive net inflows since September 2018.  With interest rates on the hop recently, the appeal of those floating-rate assets grows relative to fixed-rate junk bonds. “I think we’re about to see a lot of demand for loans,” Gershon Distenfeld, co-head of fixed income at AllianceBernstein, tells the Journal.

The private equity industry is counting on it.  The Financial Times reports today that p.e. is “seizing on ultra-low borrowing costs to fund a flurry of acquisitions,” in some cases tacking additional debt on to already leveraged portfolio company balance sheets.  Thus, medical equipment firm Protective Industrial Products will carry net debt equal to more than seven times Ebitda once p.e. firm Odyssey Investment Partners completes its first- and second-lien loan offerings to finance its purchase of the company, while BC partners will soon issue its own pair of loans to finance the purchase of Women’s Care Florida, leaving the healthcare network sporting a leverage ratio of more than nine turns of debt. Both deals, the FT notes, are being marketed with all-in yields south of 6%. By comparison, average loan yields spiked above 13% during the teeth of the March selloff.

There may be more where that came from;  the hefty cache of p.e. “dry powder” ($860 billion worth according to Preqin, up from $760 billion at the end of 2019), in tandem with buoyant asset prices rendering investment bargains few and far between, equals “a formula for a lot of aggressive transactions,” concludes Steve Columbaro, loan portfolio manager at Columbia Threadneedle. 

QE progress report
A second straight weekly decline left Reserve Bank Credit at $7.28 trillion, as interest bearing assets at the Fed slipped $25 billion sequentially and $69 billion from two weeks ago.  That slowed the annualized three-month growth rate to 17.7%, while the year-over-year increase stands at 77.4%. 
Recap Jan. 14

A late 50 basis point selloff left the S&P 500 at session lows and shaved the broad index’s January advance to 1%, while the VIX jumped 5% into the bell to finish back above 23.  Treasurys came for sale in bear steepening formation following a two-day bounce, as the 10- and 30-year yields rose to 1.13% and 1.87%, respectively. WTI rallied to near $54 a barrel and gold edged lower to $1,848 per ounce.

- Philip Grant

Chasing it
Let the spinning wheel spin.

Let the spinning wheel spin.  Last year marked a watershed for the Nasdaq, as the exchange announced yesterday that it led all exchanges in total equity options trading volume, including a record 2.58 billion options contracts, a 52% jump over 2019.  Similarly, CME Group, the world’s largest derivative exchange, reported that daily volume within its equity index and option categories footed to 5.6 million contracts last year, up 63% from the 2019 level. 

Some observers think the trend has more room to run. Noting that only about 20% of customers on the popular Robinhood trading app currently deal in options, Cboe Global Markets head of derivatives and global client services Arianne Criqui told Bloomberg in an interview last November that she sees “great upside” for the category. 

Vanilla trading activity is likewise on a rampage.  Some 14.8 billion shares changed hands daily last week across major U.S. exchanges, “ranking,” according to Bloomberg, “among the busiest stretches of all time.” One particular demographic can take credit:  Retail investors threw their collective weight around like never before in the pandemic-riddled 2020, accounting for as much as 25% share of daily trading activity on peak days, according to a July estimate from Citadel Securities head of execution services Joe Mecane.  In 2019, that figure was closer to 10%. 

As Mr. Market continues to reward those newcomers with a gangbusters bull market, speculative elements take center stage. The Wall Street Journal noted yesterday that Chinese electric vehicle maker NIO, Inc. has been one favorite target of the day-trading hordes, with the company mentioned on Twitter some 6,800 times per day in November compared to 100 daily mentions at the start of 2020, while the stock has mushroomed to $62 per share today compared to less than $4 a year prior.  NIO, which is expected to post adjusted Ebitda of negative $239 million this year, now has a $98 billion market capitalization (approaching that of Ford and General Motors combined) and was the second-most actively traded stock in the U.S. last year with an average 111 million share daily trading volume, trailing only Apple, Inc. 

That modern day success story has spawned plenty of would-be competition. According to data from Themis Trading, six penny stocks (meaning those trading for less than $1 a share) accounted for 18% of total stock market trading volume on Monday, with a combined 2.6 billion shares in turnover. “I thought it was pretty odd,” Joe Saluzzi, co-head of equity trading at Themis, told Bloomberg. “There’s a risk it may not end well.”  Yet, so far, so good. Stocks within the Russell 3000 priced at less than $1 a share jumped by an average 13% through the first six trading days of the year, while those priced below $5 were up nearly 10%. The index itself rose a bit less than 2% over that period.

As Joe and Jane Six Pack chase stock market riches, one avatar of the current mania looks to cash in. Robinhood, which garnered an $11.7 billion valuation in a Series G funding round in September, is preparing to launch an initial public offering as soon as the first quarter. Keeping with the spirit of the times, the company is looking to dance with who brung them. Bloomberg reported last week that Robinhood “has weighed allocating a significant minority of the shares it will list” to its own users.  

On Dec. 17, the commission-free trading venue paid a $65 million fine to the Securities and Exchange Commission to settle allegations that Robinhood, from 2015 to 2018, “made misleading statements and omissions in customer communications” related to “its largest revenue source,” i.e. receiving payment from high frequency traders for its order flow, in turn leading to its customers receiving “inferior trade prices.” By way of response, chief legal officer Dan Gallagher declared that the fine “relates to historical practices that do not reflect Robinhood today.” In any event, that regulatory smackdown (or wrist slap) appears not to have stung too badly. TechCrunch noted in December that Robinhood saw revenues from order flow payments reach $180 million in the second quarter of last year, double that of the first quarter. 

Robinhood users-cum-shareholders paying themselves for their own order flow: A coming 2021 singularity? 

Recap Jan. 13

A strongly bid long bond auction spurred another extension of yesterday’s Treasury rebound, as the 10- and 30-year yields dropped in bull flattening fashion to finish at 1.09% and 1.83%, respectively.  Stocks caught another bid, with the S&P 500 logging its sixth green finish in seven tries following a near 2% pullback to open the trading calendar year.  WTI crude slipped back below $53 a barrel, gold ticked higher to $1,849 an ounce, and the VIX dropped below 22 to extend its two day loss to 8%. 

- Philip Grant

Walk the Line
On Jan. 1, China officially rolled out

On Jan. 1, China officially rolled out its “three red lines” policy governing the nation’s property sector. The new rules, designed to limit systemic risk resulting from leveraged capital structures, compel developers to cap liabilities at 70% of total assets and net debt at 100% of equity, while short term borrowings must not exceed cash reserves. Those that fail to meet these metrics will be barred from growing liabilities for one year. 

The powers that be are making sure the message is received loud and clear. Bloomberg reported yesterday that Beijing is set to expand its watchlist of property developers within the three red lines program, with an additional eight concerns set to join the original list of 12 companies who must comply before they are permitted to issue additional debt. That follows a Dec. 31 edict from the People’s Bank of China capping the proportion of property loans on the balance sheet of the four largest state owned banks at 40%, while mortgages can account no more than 32.5% of total outstanding credit. 

Real estate distress adds urgency to the current crackdown. This morning, double-B-minus-rated China Fortune Land Development Co. Ltd.’s senior unsecured 8.6% notes due 2024 fell below 50 cents on the dollar, according to data from Bloomberg, a fresh nadir and down from 86 cents as of Dec. 31. That precipitous plunge is ominous indeed, as the company faces some $4.4 billion in principal and refinancing commitments over this year, equivalent to roughly 40% of its marketable debt outstanding. 

Then, there’s China Evergrande Group (3333 on the Hang Seng), the Middle Kingdom’s largest and most encumbered developer as well as Asia’s most prolific issuer of junk bonds.

Recall that, last fall, the company narrowly averted disaster by persuading a consortium of investors to not demand repayment of RMB 130 billion ($19.5 billion) in funds linked to an abandoned backdoor listing on the mainland Chinese market, a sum equivalent to nearly all its cash and cash equivalents as of June 30 last year. Single-B-rated Evergrande carries some $124 billion in net debt (equivalent to nearly eight times consensus 2021 adjusted Ebitda), including the dollar pay 8 3/4% senior secured notes due 2025, which last changed hands near 83 cents on the buck for a yield-to-worst of 14.3%. 

An unsuccessful recent balance sheet gambit further colors Evergrande’s precarious position.  The debt-laden company anted up some HK$1.3 billion ($170 million) to fund share buybacks in the fourth quarter. Yet Evergrande shares are off by more than 10% since the buyback’s Dec. 2 completion, compared to a near 7% advance from the Hang Seng Index over that period. 

More broadly, the real estate clampdown could reverberate, as Chinese households put forth $1.4 trillion worth of housing-related investment outlays in the 12 months through June 2020 according to FactSet, far above the $900 billion annual pace that Americans invested at the peak of the early- and mid-aughts U.S. housing bubble. As the South China Morning Post concluded last week: “Any overkill of the cooling measures could slow one of China’s main growth engines – residential sales and prices are expected to decline in 2021 – to such an extent that it may become a major blow to economic recovery.” Stateside observers concur. Back in August, a paper from the National Bureau of Economic Research determined that “a 20% fall in real-estate activity could lead to a 5% to 10% fall in GDP, even without amplification from a banking crisis, or accounting for the importance of real estate as collateral.” 

There appears to be more than sufficient tinder for a four-alarm financial fire: Chinese banking assets stood at $46.4 trillion as of Sept. 30, more than double the $20.6 trillion in U.S. bank assets at year end and more than half of the $88 trillion in nominal global GDP for 2019. Logan Wright, director of China markets research at Rhodium Group, expressed his concerns to Grant’s in October:

China’s rapid debt accumulation over the past decade is now showing its teeth and is increasingly unmanageable, particularly in some localities where credit growth has already slowed sharply. Beijing can manage the Evergrande problem, but not China’s broader debt burden.

For more on Evergrande, the encumbered property sector and hidden (and not-so-hidden) risks within the Chinese economic miracle, see the Oct. 2 edition of Grant’s Interest Rate Observer

Recap Jan. 12
A home run 10-year Treasury auction spurred a bullish rebound in interest rates and perhaps stocks as well, as U.S. Treasury yields reversed early losses to leave the curve little changed while the S&P 500 erased a 60 basis point intraday decline to rebound back to yesterday's perch near all-time highs.  WTI crude jumped back above $53 a barrel, gold ticked higher to $1,856 an ounce, and the VIX finished 3% in the red after climbing back above 25 intraday.  
The Class of 2021

Here’s NBC Los Angeles, summarizing some Friday commentary from California Governor Gavin Newsom: 

Gov. Gavin Newsom forcefully pushed back on criticisms that California is becoming unfriendly for business, pointing to “all the new billionaires” created by initial public offerings and noting that its richest people are “doing pretty damn well.”

Apollo 13
A match made in heaven?

A match made in heaven?  This morning, Intercontinental Exchange, Inc. (ICE) announced that it will take its Bakkt Holdings, Inc. cryptocurrency payment business public.  The deal will take place via a merger with special purpose acquisition company VPC Impact Acquisition Holdings, Inc. at a proposed $2.1 billion valuation.

That intersection of cryptos and blank check companies is a both a notable contemporary signpost and an ironic development. ICE, the parent company of the New York Stock Exchange, would seemingly have little trouble listing Bakkt via a conventional initial public offering, but instead opted for the SPAC route, despite the fact that VPC’s owners will dilute the exchange operator via the blank check company’s promote.  

Less-than stellar operating projections further color the move.  According to the S-1 filing, Bakkt expects to generate negative adjusted Ebitda through calendar 2022 and a modest $285 million in adjusted Ebitda by 2025, despite penciling in $6.6 billion in total revenue for that period, compared to a forecasted $889 million top line this year.

In an interview with The Wall Street Journal, ICE CEO Jeffrey Sprecher termed the two-year old Bakkt a “moonshot” bet, adding today that “it’s well off the launchpad and headed for the moon.”

Learning by Doing
Bank of England monetary policy committee member

Bank of England monetary policy committee member Silvana Tenreyro talked up the virtues of negative interest rates in a webcast speech this morning, concluding that sub-zero rates “should, with high likelihood, boost U.K. growth and inflation.”  

Tenreyro continued: “There was some resistance to negative rates – we have all been brainwashed that you cannot go there. We learn it in our textbooks, so there was a big predisposition not to go below zero. . . [However], low rates are here to stay, so it’s important that we consider this as an option.” 

Some on Wall Street are convinced that the BoE will indeed make NIRP a reality.  Strategists at Goldman Sachs write today that: “Although increased fiscal support has weakened the case for a quick rate cut, the U.K. has still been one of the countries worst affected by the pandemic, and, combined with the negative effects of Brexit, it means we continue to expect that the bank will ultimately be forced to take rates negative.” 

In that regard, the Bank of England would have plenty of company. The global stock of negative yielding debt stood at $17.43 trillion as of Friday, near a record high and more than double that seen in March of last year.  As yields evaporate, income-famished investors grab what they can. Last week, triple-B/triple-B-minus-rated Italy sold €10 billion ($12.2 billion) in 15-year debt at a 0.95% coupon, with the offering attracting more than €100 billion worth of bids. “People want Italian bonds,” Imogen Bachra, European rates strategist at NatWest Markets, told Bloomberg. “There will be lots of supply for the market to take down in the next few weeks.”  

Good thing low rates are here to stay. 

Recap Jan. 11

Stocks came under some pressure, with the S&P 500 dropping 65 basis points while the tech-heavy Nasdaq 100 saw a 1.6% pullback and bitcoin was hammered by 15%.  Treasurys remained for sale as the 10-year yield rose to a fresh 10-month closing high at 1.14%, gold edged higher to $1,845 an ounce and WTI crude held near $52 a barrel.  The VIX jumped back above 24, finishing the day 12% in the green. 

- Philip Grant

Vulcan Neck Pinch
The check, please.

The check, please. It’s been a banner start to 2021 for special purpose acquisition, or blank check, companies.  According to data from SPAC Insider, 13 such deals priced today, raising a combined $3.4 billion to bring this week’s total to 27 SPAC initial public offerings and $6.5 billion in proceeds, respectively. For context, calendar 2020 saw some 248 of those debuts totaling $82 billion according to Dealogic, topping the output of all previous years combined.  

Needless to say, the structure, in which sponsors raise money from investors then hunt for a business to acquire, has plenty of advocates.  Retail investors gain the ability to easily trade equity shares in previously-private businesses, while promoters sidestep the regulatory scrutiny that accompanies traditional IPOs and savvy investment insiders acquire warrants and rights in the underlying entity, allowing them to participate in any upside with little or no risk. 

The deal frenzy has included numerous entities co-sponsored by non-financial notables, including former Speaker of the House Paul Ryan, NBA legend Shaquille O’Neal and former astronaut Scott Kelly.   

The cohort likewise includes some familiar financial faces. Social Capital founder and CEO Chamath Palihapitiya is preparing his fifth SPAC deal of this cycle, announcing yesterday a merger between sponsor Social Capital Hedosophia Corp. V and nine-year-old financial technology concern SoFi.  Yesterday, SoftBank Investment Advisors-sponsored blank check company SVF Investment Corp. raised $525 million through a Nasdaq-listed IPO.  The entity, helmed by Rajeev Misra, the CEO of Vision Fund (SoftBank’s in-house venture capital arm), has identified the artificial intelligence and robotics realms as potential areas of interest. The filing notes that SVF is “not prohibited from pursuing an initial business combination with a company that is affiliated with SBIA, the SoftBank Vision Funds, our sponsor, officers or directors.” 

Unsurprisingly, the raging fad has garnered the Street’s undivided attention.  The Wall Street Journal reported Tuesday that as SPACs accounted for nearly half of all total IPO activity last year, bulge bracket banks such as Credit Suisse, Citigroup and Goldman Sachs have “muscled in” to the blank check underwriting market, supplanting smaller competitors such as Cantor Fitzgerald, which had been the leader in the heretofore niche category.  “Even the firms that wouldn’t touch the product a couple of years ago all of a sudden want to be part of the game,” Alysa Craig, managing director for mergers and acquisitions and head of SPACs at Stifel Financial Corp., told the Journal

But while promoters and insiders cash in and Wall Street races to the scene, a recent academic analysis argues that investors would be well served to give SPACs wide berth. A Nov. 16 paper from professors Michael Klausner at Stanford Law School and Michael Ohlrogge at the New York University School of Law found that, from 2010 to 2019, the blank-check entities produced negative one-year, post-merger returns on average, with losses ranging from about 10% from the 2010 vintage to more than 70% for the 2014 cohort. 

Structural factors, including hidden costs and often-severe investor dilution, loom large in explaining that poor performance: While each SPAC traditionally raises $10 per share at the time of its IPO, those vehicles hold just $6.67 per share in cash on average at the time the SPAC finally merges with a target, representing a huge hidden cost for investors.  Messrs. Klausner and Ohlrogge conclude:

We find, first, that for a large majority of SPACs, post-merger share prices fall, and second, that these price drops are highly correlated with the extent of dilution, or cash shortfall, in a SPAC. This implies that SPAC investors are bearing the cost of the dilution built into the SPAC structure, and in effect subsidizing the companies they bring public. We question whether this is a sustainable situation.

Might Mr. Market one day soon turn his fickle attention to the flaws inherent within the SPAC format? In the meantime, see the issue of Grant’s Interest Rate Observer dated Dec. 25. for a review of the brand new Grant’s SPAC Index and each of its 10 components. “It’s not meant for buying.”

Recap Jan. 8

Stocks continued their rampage, with the S&P 500 putting the finishes on a blistering four-day rally to end the week higher by 1.9% following Mondays aggressive selloff.  Treasurys remained under notable pressure, with the 10-year yield closing above 1.1% for the first time since March, while key commodities went in opposite directions with WTI crude ripping 3.5% to near $53 a barrel and gold bludgeoned by 3.5% to $1,867 an ounce. The VIX fell 3% to 21.7, near its lowest close in a month. 

- Philip Grant

Synchronized Swim
The bond market percolates down Mexico way.

The bond market percolates down Mexico way.  On Monday, Mexico’s finance ministry announced a successful debut sale of 50-year Formosa bonds (dollar-denominated bonds sold on the Taiwanese market) at a 3.75% coupon, with the $3 billion offering more than three times oversubscribed. 

While the triple-B/triple-B-minus-rated Mexican government opportunistically finances itself, state-owned oil giant Petróleos Mexicanos (a.k.a. Pemex) reportedly prepares its own return trip to the bond market. In October the company sold $1 billion, dollar-pay five-year notes priced-to-yield 6.95%, well inside price talk of 7.5% to 8%. 

Less traditional balance sheet machinations are also on the table for highly indebted Pemex. On Dec. 15, the company declared it had carried out a refinancing “financial operation” to relieve some $4.8 billion in near-term debt maturities, including a $2 billion payment scheduled for this month. Pemex, which was downgraded to junk by Moody’s and Fitch in April to become the world’s largest fallen angel, carries some $105 billion in financial debt along with $68 billion in pension obligations as of Sept. 30, a combined sum equal roughly 18 times calendar 2019 Ebitda. Third quarter 2020 Ebitda of $2.4 billion was half that of the year earlier period. 

Acute and long-gestating operational problems compound Pemex’s precarious capital structure, including a cumulative $87 billion free cash flow deficit from 2010 through Sept. 30 of last year.  Persistent production declines, to 1.63 million barrels per day in November from 1.7mbpd in the same month in 2019 and a peak of 3.4mbpd in 2004, further muddy the financial waters. 

“It’s a bigger and bigger hole,” Simon Waever, strategist at Morgan Stanley, told the Financial Times yesterday. Waever projects that Pemex will need to raise another $10 billion from the bond market this year, including $5 billion in January. One unnamed former senior official at the company added that “Pemex’s situation is much worse than the market thinks. They’re burning through cash at the speed of light.”  

Pemex’s woes may compel more assistance from the Mexican government, led since 2018 by Mexican President Andrés Manuel López Obrador (AMLO). The company’s tax rate is expected to foot to 54% of profits this year, deputy finance minister Gabriel Yoro estimated to Reuters on Dec. 9, down from 58% last year and 65% in 2019. Then, too, Fitch Ratings wrote on Dec. 17 that the agency’s base case expectation “incorporates the assumption that Mexico would cover [Pemex’s] expected negative free cash flow projected for the next few years.” Pemex’s projected tax revenues account for 15% of Mexico’s federal budget for 2021. 

Since a bearish analysis in the March 23, 2018 edition of Grant’s, Pemex’s 6 3/4% senior notes due 2047 have seen their spread widen to 573 basis points from 399 basis points, while five-year credit default swaps have jumped to 398 basis points from 192 basis points.  Yet, Mexican sovereign five-year CDS have declined to 81 basis points from 114 basis points over that period, despite a trio of rating downgrades during the spring of 2020.

Might the pair’s fortunes be more closely tied than Mr. Market currently expects? Moody’s warned on Dec. 8 that “a change in our assumptions about government support and its timeliness could lead to a [further] downgrade” for Pemex, while, in the case of a further downgrade to the sovereign, Pemex’s “baseline credit assessment would have to substantially improve” to maintain its own Ba2 rating.   The rating agency pegs Mexico’s sovereign rating at Baa1 (three notches above junk) with a negative outlook.  Indeed, the capacity for sovereign assistance has its limits. “The ability to continually implement ad hoc, one-time support measures is going to diminish over time,” Patti McConachie, senior analyst at Columbia Threadneedle, told the FT

Financial fallout from the country’s recent political shift continues to loom large. AMLO, long an advocate for state control over the Mexican energy patch following his predecessor's move to open the industry to outside competition, suspended auctions for deep water drilling licenses for foreign operators shortly after taking office. That move has led to a cascading project pile-up, as more than 200 energy ventures were stalled as of mid-October, Bloomberg reported Dec. 22.  That compares to fewer than 30 such discontinued energy projects six months prior to AMLO’s ascent.

The President’s “clear goal is to change the rules of the game so that the state once again has the upper hand and can dictate the terms on which private money comes into the system,” Duncan Wood, director of the Wilson Center’s Mexico Institute, told Bloomberg. “Everything points to the fact that he wants to close the system again.” 

Pemex and Mexico sovereign creditors alike, please copy. 

QE Progress Report
Reserve Bank Credit (the sum total of interest bearing assets at the Fed) footed to $7.307 trillion this week.  That’s down $43 billion from a week ago but still represents an 18% three-month annualized growth rate, and a 77.8% year-over-year increase. 
Recap Jan. 7

Another day, another dollar for the bulls, as stocks ripped higher once more to leave the S&P 500 above 3,800 for the first time, a cool 70% above its March nadir.  Treasurys came under renewed pressure with the long bond yield jumping to 1.86%, leaving the 2- vs. 30-year spread at its widest since May 2017.  WTI crude rose to near $51 a barrel, gold edged higher to $1,915 an ounce and bitcoin touched $40,000 after residing near $36,000 yesterday afternoon.  The VIX fell 11% to settle below 22.5. 

- Philip Grant

Agent Zero
A year to remember in credit,

A year to remember in credit, as the March panic has quickly given way to something resembling an opposing extreme. Last week, the Goldman Sachs Financial Conditions Index reached its most accommodative level on record going back to 1990, while total corporate bond issuance foots to a record $2.5 trillion for the year according to Bank of America. Thanks to that borrowing spree, gross leverage among investment grade and junk borrowers has reached record highs near four and six times Ebitda, respectively, the Financial Times reports today.

Needless to say, the Federal Reserve’s March 23 announcement that it would, for the first time, directly purchase investment-grade corporate debt, loomed large in the bond market’s dramatic turnaround.  Indeed, Jonny Fine, U.S. head of debt syndicate at Goldman Sachs, describes those interventions to the FT as: “the most important piece of central bank policymaking I have seen in my career.” 

One bit of price action captures Mr. Market’s mood:  Yesterday, Ford Motor Co.’s senior unsecured 5.29% bonds due 2046 changed hands at a 332-basis point pickup over Treasurys, well inside the-938 basis point peak in early April and tighter even than the 341-basis point spread seen at the end of January. That’s despite the auto giant joining the ranks of so-called Fallen Angels this spring, as all three major rating agencies downgraded Ford’s debt to junk between late March and May.  

Airbags deployed. 

Factory Fresh
Total U.S. equity sales from corporations and controlling shareholders have rocketed to a record $435 billion so far this year,

Total U.S. equity sales from corporations and controlling shareholders have rocketed to a record $435 billion so far this year, Bloomberg reported yesterday, easily topping 2014’s prior high water mark of $279 billion.  Initial public offerings account for $100 billion of that sum, also a record exempting 2014, which featured the American Depository Receipt listing of Chinese e-commerce behemoth Alibaba, Inc.   

Those wide-open markets have of course fostered some big gains, as companies raising $1 billion or more have enjoyed an average 81% pop since going public. Mega-cap debuts have seen a particular frenzy, with Snowflake, Inc. shares enjoying a 185%, 10-week rally while DoorDash, Inc. and Airbnb, Inc. shares ripped 86% and 113%, respectively, on their first trading days earlier this month. “What we’re seeing is deals often overshooting fundamental value,” observed Paul Abrahimzadeh, co-head of equity capital markets for North America at Citigroup. “Record high growth multiples are directly related to lower rates. Anything that grows in a low growth environment gets a massive premium.” 

Of course, those outsize post-IPO stock pops are making some would-be sellers nervous, as they represent lost opportunities to earn even larger windfalls from currently-ravenous investors.  The Wall Street Journal reported Dec. 11 that videogame developer Roblox Corp. will delay a planned public debut until at least January. “Based on everything we have learned to date, we feel there is an opportunity to improve our specific process for employees, shareholders and future investors both big and small,” CEO David Baszucki wrote in a memo to staff. That same day, fintech Affirm, Inc. followed suit, with “the extreme first-day pops this past week. . . and delays at the Securities and Exchange Commission amid a flooding of listing requests,” among the primary factors, per the Journal

Then, too, the IPO gold rush has helped corporate insiders consolidate their empires. The Journal relays today that both the DoorDash and Airbnb boards have bestowed 20-vote-per-share privileges on the company’s co-founders in recent months, while directors at data analytics firm Palantir Technologies, Inc. granted a trio of co-founders the ability to maintain a controlling interest while maintaining equity ownership of as low as 0.5% of shares outstanding.  

That trend has its proponents. Founders “have earned the right to have that control,” as it allows them to focus on “building an enduring business rather than a short-term business focused on quarter-to-quarter results,” contends Alfred Lin, partner at Sequoia Capital and board member of both DoorDash and Airbnb.

On the other hand, the super-voting trend ushed in by industry mainstays Google and Facebook has now become endemic to Silicon Valley, with more than 40% of this year’s tech IPOs featuring a dual class structure, up from 7% in 1980.  Nell Minow, vice chair at ValueEdge Advisors, sums it up from the investor perspective: “There’s more money than there are good deals.” 

Recap Dec. 22

Stocks edged slightly lower, with the broad S&P 500 logging its third straight red finish, totaling about 1%, after last reaching a fresh high-water mark on Thursday.  Treasurys continued their rebound with the long bond ticking to 1.65%, gold and WTI fell below $1870 an ounce and $47 a barrel, respectively, and the VIX slipped back below 25 after logging a five-week closing high yesterday.  

- Philip Grant

Almost Daily Grant's will resume on January 7th

Banana Split

As Uncle Sam prepares to dole out $600 checks to the populace, some stock-minded recipients note the relatively diminished buying power of the latest fiscal stimulus round.  An overheard investor lament, relayed by Twitter account @AlbertBridgeCap:

This sucks, I could buy 11 shares of Tesla post-split with that first stimulus check, and with this second check, I can’t even buy 1.

Of course, stock splits have their aficionados.  As Barstool Sports’ David Portnoy tweeted on Aug. 25:

Why do I like when stocks split? Because you get double the stocks. Two stocks are better than one especially when they always go up.

M&A Blues
Time to change the channel.

Time to change the channel. The New York Post reports that AT&T, Inc.’s efforts to dispose of its DirectTV unit have run aground. Frustrated with the prospective price tag for the satellite television business, AT&T has delayed its deal deadline until January, and informed would-be bidders that it might scrap the sale entirely if the price is wrong.   

The Wall Street Journal reported Dec. 9 that bids had exceeded $15 billion, including the assumption of debt. “Dissatisfied with those offers,” AT&T has allowed prospective bidder TPG Capital to inspect DirecTV’s financials in hopes the private equity firm will place a binding offer and breathe life into the auction, the Post relays.  

Even a sum well above that $15 billion figure would be painful, as AT&T coughed up a cool $66 billion, inclusive of debt, for DirecTV in 2014.  Beset by persistent subscriber losses (including a 19% drop in the third quarter from a year ago), the unit will see Ebitda fall to $3 billion in 2022 from this year’s projected $4.5 billion, if estimates from New Street Research are on point. 

Ma Bell’s aggressive balance sheet raises the stakes in the DirectTV negotiations.  With a towering $200 billion debt load counting pension liabilities and operating leases, AT&T stands as the most encumbered nonfinancial company in the world, while leverage of 3.5 times consensus 2021 Ebitda is almost a full turn higher than the average among its Baa-rated cohort, according to a September analysis from Moody’s.  That extensive debt load, in tandem with diminished prospects for generating substantial proceeds from a DirectTV sale, threatens AT&T’s hefty 7% annual shareholder payout. Craig Moffatt, co-founder and one-half eponym of research firm MoffettNathanson, LLC, writes today that Ma Bell’s “leverage is too high to be confident about dividend sustainability” (for more on AT&T, see the Dec. 13, 2019 edition of Grant’s Interest Rate Observer).  

While the AT&T c-suite works through buyer’s remorse, one shale player laments the deal that got away.  Today, Diamondback Energy announced it will buy driller QEP Resources, Inc. in a $555 million, all-stock deal equal to roughly $2.22 per share, based on current trading levels.  That price represents a discount to QEP’s $560 million market cap as of Friday, spurring a selloff of as much as 11% in the target company’s shares today as frustrated investors headed for the exits. 

For QEP, missed opportunities color today’s transaction. Last year, minority shareholder Elliott Management Corp. bid $8.75 a share to acquire the remaining 95% of the company it did not own, valuing the equity at some $2 billion. That approach was followed by an “intense” 90 day negotiation that broke down after the parties “couldn’t come together on price,” Bloomberg reported in August of last year.  After deal talks fizzled, QEP CEO Tim Cutt explained management’s rationale: “As we evaluated opportunities, it was apparent that none of the potential transactions recognize the intrinsic value of our assets.”

Recap Dec. 21

Stocks rebounded from sharp early losses, as the S&P 500 closed to within 40 basis points of unchanged to leave the broad index higher by 14.4% this year with seven trading sessions left in 2020. Treasurys caught a bid after last week’s selloff, with the long bond dropping two basis points to 1.67%, WTI crude pulled back below $48 a barrel, and gold edged lower to $1,881 an ounce.  Despite paring the bulk of its early gains, the VIX managed to finish higher by 17% for its first close above 25 since Nov. 12. 

- Philip Grant

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