Blain's Morning Porridge - Jan 12th 2018. Junk and Distressed Debt - The games people play!
Blain’s Morning Porridge – January 12th 2018
“Toto, I’ve a feeling we’re not in Kansas anymore….”
The Morning Porridge is unrestricted market commentary freely available to all qualified investors on an unsolicited basis. It is not investment research.
This morning we are waiting for a puff of white smoke from the Chancellery in Berlin, heralding a last minute new Merkel government. As I write a deal is apparently being spell-checked… More Europe and a leftwards shift? What happens if it doesn’t happen? That will be interesting…
Germany might be rudderless, but Europe is on a roll. France is the new new thing. Even Italy is bright and shiny. The economic data is strong, robust and if there is still a massive yoof unemployment issue across the periphery, let’s not let it spoil the narrative. The ECB minutes say they might bring forward their plans, but they remain inflation data dependent.. You put your left leg in, your left leg out....
Meanwhile, how important is the Junk Bond market to the economy and markets? How critical are cash stressed firms on the financial edge for growth? These questions are in focus as rates start to edge higher. How many junk issuers are about to tumble, default and descend into the distressed sector? Some interesting ideas thrown up at distressed and high-yield forums in recent days – backing the notion that low interest rates have sustained a whole raft of Zombie companies and therefore preserved jobs, but at a cost of decreasing productivity. If rates rise, Zombie companies will fail – creative destruction – and hopefully the jobs will be replaced by better ones in live growth firms.
The Hi-Yield junk market has grown dramatically in recent years, fuelled partially by former investment grade investors being forced down the credit curve in search of yield, but also more and more speculative grade issuers seeking finance. Bingo – everyone is happy! Until it starts to go wrong. Demand had extended from the traditional troubled sectors like energy and retail, right across the full spectrum of issuers and sectors.
Bloomberg’s Credit Newsletter highlights $1 trillion of speculative debt, but rising stress across 40% of US industry sectors this year, up from 9% last year! The story reports distressed specialists anticipating further negativity this year, and the possibility of contagion right across the economy as companies start to buckle – normally distressed debt contagion is focused within stressed individual sectors. Pundits fear its about to go mainstream and global.
Of course, all these recent investment grade investors who’ve piled into Junk – explaining the yield compression right across the sector – completely understand these risks… (US readers…) Perhaps they might take solace in the following tale…
If you’ve ever wondered just how murky the world of corporate debt and credit derivatives can get, then consider US homebuilder Hovnanian. We’ve got hedge funds threatening to sue hedge funds for manipulating the credit default market, and the credit default providers staring at massive losses.
Hovnanian overextended itself, and faced a 9x short-dated debt to EBITDA ration with a big bond redemption coming up. Its largest lender, GSO, smelt the opportunity, lent it new finance and extended its maturity profile to smooth its debt load. But, the rinky-dink was the company agreed to engineer a technical default on its debt, thus triggering Credit default swaps, allowing GSO and other to reap millions. Its been structured in such a way as the payments will be massive – the CDS writers Goldman (if they are looking for sympathy, they find it between sh*t and syphilis in a dictionary), and Solus, are screaming foul! But, nothing GSO has done is actually illegal! They are also equity holders – which has surged!
If it looks and smells like a con… then wake up and smell the coffee. Its feels like the Greed is Good 1980s. While we ordinary folk might be wondering just how dysfunctional the market is, I’ll also bet there isn’t a single high-yield desk that isn’t looking for similar opportunities. This is the way Junk and Private Equity dance.. Read the small print, don’t assume folk are doing anything for the common good, and face the future glancing over your shoulder.
Read the whole story in the FT: https://www.ft.com/content/69194bda-f5af-11e7-88f7-5465a6ce1a00
We don’t even blink when seen firms owned by PE investors drown themselves in debt to pay dividends, and now we’ve got manipulation of the CDS market. What next? What does it all mean for the real economy and jobs?
And back in the real world, my Stock Picking guru, Steve Previs has been casting his eyes over the continuing inflows into the US stock markets – some $24 bln last week, over half into passive ETFs. Hardly a rush for the exits. Steve helpfully provided me with a list of why we should keep buying the Melt-Up market:
●Stock buybacks
●M&A
●Shrinking Share Availability
●Shrinking Universe of Issues
●Corporate Overseas Profit Repatriation
●Cash Flows Into Passive Investments (Indexing)
●Moribund IPO Market
Can’t argue with any of it.. for now..
Back to the day job, and have a great weekend..
Bill Blain