16Apr2020-cover
16Apr2020-cover
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The Frankenstein Fed Is Not Saving Everyone

Despite unprecedented actions by the Fed in the wake of COVID-19, high yield borrowers do not have a Fed liquidity back stop. Fundamental price discovery should continue for these businesses with respect to their balance sheet solvency (i.e. capital structure) and cash flow solvency (operating structure / business model). Over the long term, no amount of liquidity will save a broken business model, while a broken balance sheet will destroy a lot of capital and replace existing shareholders.

– Amit Nath

 

Much has been written about the unprecedented size and scale of the actions taken by the U.S. Federal Reserve Bank in recent weeks to support the U.S. economy and markets. Starting with cutting interest rates by 150bps to 0%, promising to purchase an “unlimited” amount of U.S. government debt (aka Quantitative Easing or Q.E.) and most controversially by creating $2.3 trillion of worth of corporate credit programs for American businesses (unprecedented). Providing liquidity to the corporate sector is controversial because legally the Fed is not allowed to buy debt that is not backed by the U.S. government, except during emergencies and in this case, on behalf of the U.S. Treasury a loop hole and nuance worth noting.

The magnitude of the current Fed actions is laid bare below for those that are more visually inclined, with the “super spike” on the right side of the chart clearly visible. As we can see the actions over the last several weeks have been orders of magnitude larger than the measures taken following the 2008/2009 Global Financial Crisis (GFC) with the other major central banks ramping up too, as the world tries to combat the COVID-19 pandemic with an avalanche of money.

Extraordinary Central Bank Stimulus Led by the U.S. Fed

Source: Financial Times

To complete the picture for those more numerically inclined, the Fed’s purchases were running at $125 billion per day when it started its program in mid-March 2020, which meant its balance sheet would likely hit $7 trillion by June 2020, or $2.5 trillion larger than its previous peak following the GFC. While run-rates can lead to distorted estimates, this doesn’t seem to be the case for expectations on how large the Fed balance sheet will get. Many major Wall Street banks currently forecast the Fed balance sheet will reach $10 trillion in the not too distant future, which would be an expansion of $4.5 trillion from pre COVID-19 levels and greater than the $3.7 trillion increase following the GFC.

The Size of the Fed’s Balance Sheet is Inflecting Vertically

Source: Federal Reserve

While it is important to be aware of what central banks are doing at the macro and market level, it is of paramount importance for the team at Montaka Global to understand how these actions may affect the equity of the companies we are looking to invest in. As we diligently implement our rigorous, bottoms up, fundamental, value investing research process, we have given significant thought to this question.

As briefly touched on above, the corporate programs the Fed has established include buying bonds and providing loans to investment grade companies (i.e. rated BBB- and above) in both the primary and secondary market. While the programs currently have $850 billion of capacity, it could easily grow if needed. One of the implications of the Fed intervening in the investment grade corporate bond and loan market was the removal of a major tail risk with respect to a negative feedback loop that was forming between secondary market liquidity and primary market activity. If you recall just a few weeks ago, the secondary market was exhibiting significant price gaping, blowing out of credit spreads and virtually no liquidity with good quality corporate borrowers unable to access capital markets to fund themselves. If left unchecked, this situation had the potential to spark bankruptcies of solvent businesses that had hit a liquidity wall and could have triggered the onset of a full-blown credit crunch, a much more significant contagion along with a deeper recession / depression. Instead of this potential outcome, the Fed became the buyer of last resort and is effectively backstopping the credit market for U.S. businesses, but NOT for all U.S. businesses (we will come back to this).

To round out the discussion of tail risks, another significant tail removed by the Fed was permitting companies that held investment grade ratings as of March 22, 2020 and are subsequently downgraded to high yield or junk (but not lower than BB-) to qualify for the Fed programs (aka “fallen angels”). Given the decaying quality of BBB credit over the last several years, the potential for mass downgrades in the wake of the COVID-19 could have overwhelmed the high yield market given the enormous size disparity (BBB market is $2.5 trillion versus $1.0 trillion high yield market). Under this scenario there was a risk the market could have frozen entirely, unable to cope with all the new entrants into the credit indices, ETFs, lack of dealer liquidity, price / yield gaping, etc. Given the Fed will step in and buy these “fallen angels”, the potential for a dislocation is greatly reduced at market level for high yield as well

While the Fed actions have mitigated a corporate credit event at market level for the time being, with seemingly unlimited support for investment grade companies and higher quality recently “fallen angels”, legacy high yield borrowers do not have a Fed back stop and fundamental price discovery should continue. Companies that have over leveraged balance sheets and are burning cash will likely need to be restructured as the Fed has not bailed them out. In fact we have seen some high profile Chapter 11 bankruptcies in high yield already, with Frontier Communications, Quorum Health, etc. filing for protection in mid-April 2020, following the Fed actions.

Given the Fed is NOT providing liquidity to high yield borrowers en mass (for the time being), the market will likely price the solvency of these businesses more organically. Whether that’s balance sheet solvency (i.e. capital structure) or cash flow solvency (i.e. operating structure aka a broken business). Obviously over the long term, no amount of liquidity will save a broken business, while a broken balance sheet will destroy a lot of capital and replace existing shareholders.

As we know from Japan, keeping zombie firms alive with liquidity is an option, but it creates an enormous dead-weight loss in the economy and we’re not sure the Fed is looking to go down that road. All this of course creates an enormous opportunity for Montaka Global on the short side, while the market seemingly prices in a “V-shaped” recovery for the entire corporate sector, we believe there will be a material amount of capital destruction before we return to levels of activity we had become accustomed to prior to COVID-19.

 

Amit Nath is a Senior Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.