Why A Massive Debt-To-Equity Swap May Be Coming

Back on April 26, I noted that anyone looking for reasons to be skeptical of the furious bounce in stocks off what seemed like a hopeless nadir late in March, didn’t have to search very far for confirmation bias.

The data was horrific, the outlook for corporate profits was similarly apocalyptic and there was still quite a bit of ambiguity around how reopening plans would develop across advanced economies, which had been in various states of lockdown for a month or more.

Four weeks on, and S&P futures pushed above 3,000 coming off the US holiday, as investors effectively “pull forward” an expected recovery, likely emboldened by widely-disseminated visuals from Americans’ Memorial Day beach jaunts, which featured football, sunbathing and no signs of anyone dropping dead on the spot from viral pneumonia.

In the linked post above, I talked about the projected collapse in buybacks, which are expected to plunge by around half in 2020, alongside other cash spending.

The corporate bid has, of course, been the single-largest source of US equity demand for years, so it’s somewhat disconcerting that it would dry up, especially when the macro outlook is the worst it’s been in at least a century.

But on top of that, I talked about a possible coming deluge of equity issuance.

Secondary offerings were already showing up from distressed entities last month, and while a wave of secondaries doesn’t have to be the end of the world (2009 was a record year for equity sales and stocks managed to surge 23%, for example), I suggested you shouldn’t overthink things.

Falling demand (in this case a possible 50% reduction in buybacks) and rising supply (XYZ billions in public equity sales) is a self-evidently bearish recipe for whatever it is you’re talking about.

Ironically, rallies could be just the motivation cash-strapped companies need to sell shares, I wrote, adding that the temptation could be amplified if debt markets are unforgiving.

Well, the Fed managed to pry open the doors for corporate borrowers, and although the terms for some deals have, in fact, been unforgiving, we’ve seen two consecutive months of record-setting IG issuance.

At the same time, the Fed’s backstop for corporate credit has meant inflows to corporate bond funds.

That’s a nice setup.

“The best way to resolve the problem about asset classes is to think about the capital structure of a company post a credit crunch”, Jefferies’ Sean Darby writes, in a new note.

“The likelihood is that a company will be focused on maximizing cashflow and on reducing their leverage [so] intuitively, CEOs will be working for bond holders rather than equity investors”, he goes on to say, adding that ongoing inflows into high yield and high-grade debt while supply is “booming”, represents “the perfect answer for a central bank dealing with a credit crunch”.

But, as Darby goes on to note, equity investors aren’t completely on board with the rally, something I touched on in “Bored Retail Investors Not ‘Main Driving Force’ Behind Stock Surge“.

“Equity funds saw their outflows streak extend to the fifth week” clocking in at -$7.6 billion globally, Deutsche Bank wrote Thursday, noting that “outflows [last] week were both from DM funds (-$4.1 billion) and EM funds (- $3.5 billion)”.

One reason for the hesitancy is valuations. Simply put, the larger the collapse in earnings expectations against a rising market, the more stratospheric the forward multiple.

As alluded to above, the further stocks run, the more tempting it will be for corporates to issue equity, especially if ongoing headlines around bankruptcies and defaults prompt credit markets to extract terms commensurate with the risk.

Jefferies’ Darby touches on this. “In the past when equity markets have moved to such valuations, primary and secondary issuance has blossomed”, he writes. “In effect, a debt-to-equity swap occurs”.

(Jefferies)

The bottom line for Darby is that “just as the central banks have engineered a debt issuance boom, equity markets are set to experience a wave of capital raisings as companies switch from issuing debt to equity”.

Coming full circle, the issue for the market is that this is set against a projected collapse in buybacks.

When supply rises (equity capital raised) and demand falls (less buybacks), prices tend to respond accordingly.

Food for thought.