The Market: May 2020

The stock market is caught in a tug-of-war between very bad economic data and a tremendous amount of fiscal and monetary stimulus. At his recent press conference, Federal Reserve Chairman Powell reiterated his “whatever it takes” position.

Whatever it takes from the Fed

What that ultimately means is unknown. But for now, the Fed is buying government and corporate debt to keep interest rates low and maintain functioning debt markets. This in turn makes it easier for companies to obtain financing to keep them going during the pandemic.

This may mean that stocks could be stuck in a trading range until there is a vaccine or an effective therapy against COVID-19.

Low interest rates make debt issuance affordable

The very low interest rates engineered by the Fed is making debt issuance affordable for companies.

However, more debt on already heavily indebted companies is not a great situation for stockholders. Less cash flow available for shareholders should translate to lower equity values.

This is not a universal case but it does mean investors need to be more careful than ever.

Similarly, bond investors are facing more indebted companies with which to invest.

Even worse, many troubled companies are issuing new debt that is secured by company assets (this is possibly the only way to attract buyers). This shrinks the pool of assets available for subordinated debt (and equity) from which to make a claim.

Cramming down

This situation is known as ”cramming or crammed down”.

Not every investment case is destined for disaster. With the Fed supporting the corporate debt market, ideally, companies can replace near-term debt maturities with longer-dated bonds giving the enterprises time for a COVID solution to appear.

With the Fed propping up bond prices, it’s hard to discern the health of a business from the company’s bond price. Company debt may well be over-priced vs the true underlying fundamentals and business risk.

Investors should always examine each opportunity on its own merits. In the current environment, this rule is even more important.

— Ian Green, Pendragon Capital Management

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