Who Cares Where You Are In The Capital Structure If The Fed Doesn’t Allow Bankruptcies?

Like many irritable observers, I lost my sense of humor with the Hertz saga in mid-June, when the company suggested it might sell equity in bankruptcy given rampant speculative interest in its shares, which were busy going nuts amid a mania in “insolvency” stocks.

To be honest, I never had much patience for the Hertz story in the first place. That disdain was evident in my initial coverage. But taking advantage of oblivious retail investors by selling worthless shares only to hand the money to people further up in the capital structure was a bridge too far.

To be fair, Hertz did make it clear in the filing that anyone who bought the stock was effectively setting money on fire. “We expect that common stock holders would not receive a recovery through any plan unless the holders of more senior claims and interests, such as secured and unsecured indebtedness, are paid in full, which would require a significant and rapid and currently unanticipated improvement in business conditions to pre-COVID-19 or close to pre-COVID-19 levels”, the company said, adding that “there is a significant risk that the holders of our common stock will receive no recovery under the Chapter 11 Cases and that our common stock will be worthless”.

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“We’ve now reached a [point] where you buy bankrupt companies and issue stock in bankrupt companies”, an incredulous Jeremy Grantham remarked that week, during an interview with CNBC.

As disconcerting as that episode most assuredly was, it’s an interesting jumping-off point for discussions around the preferable place to be in the capital structure in a post-pandemic reality where the Fed is effectively backstopping investment grade credit and fallen angels.

Some argue that blue-chip US corporates are now akin to GSEs — that is, they come with an implicit government guarantee.

In fact, the Fed has made it explicit that companies should not be allowed to go bankrupt due to the pandemic. That’s something different from saying the central bank guarantees all high-grade paper under any circumstances, but it does suggest that to the extent otherwise healthy corporates can plausibly tie operational difficulties and/or a rise in borrowing costs to the virus, the Fed will ameliorate the situation.

The table shows the Fed’s individual corporate bond portfolio as it stood midway through last month (full discussion is here).

With all of that in mind, it’s worth asking what the utility is of being a creditor versus being a stockholder in an environment where yields on investment grade corporate bonds have converged on dividend yields for equities.

“Amid significant uncertainty and heightened risk aversion, it is unsurprising that the spread between bond yields and dividend yields has compressed”, BMO’s Daniel Krieter wrote, in a note dated Friday. “Investors are willing to accept lower and lower yield to gain the safety of bonds when bankruptcy fears are elevated”, he added.

As you’re aware, bankruptcy fears are, in fact, elevated — or at least for companies that can’t access the Fed’s facilities or secure a taxpayer bailout. The pain is particularly acute in retail and energy.

When it comes to companies that have remained afloat, investor demand for credit theoretically has its limits. Past a certain point, the allure of equities’ unlimited upside may outweigh the comfort of being higher up in the capital structure, at which point money will flow into stocks, and bond yields will rise.

But, as BMO goes on to point out, the spread between bond yields and dividend yields keeps compressing, and we’ve now reached the point where IG yields are on the verge of dipping below dividend yields.

At that point — i.e., when dividend yields and corporate bond yields are equal — the rally in credit could be capped, especially in an environment where quality companies are seen as effectively carrying a Fed/Treasury guarantee.

“How valuable is higher placement in the capital structure if bankruptcy is extremely unlikely?”, BMO’s Krieter wonders. “When talking about investment grade companies, the chance of bankruptcy is very low to begin with”, he notes, adding that when “a central bank/government [is] actively trying to ensure that as few entities default as possible, the chance of bankruptcy drops evens further”.

Indeed. And, assuming you’re a multi-asset investor whose mandate doesn’t preclude equities, the incentive to stick around in investment grade credit versus, say, the equity of companies with strong balance sheets, is commensurately diminished in a scenario where your place in the capital structure is rendered meaningless by virtue of the Fed/Treasury effectively declaring a moratorium on bankruptcies.

Think on that.