Sugar on top. Stocks overcame an early deficit yesterday and rallied into the close after the Fed made good on its earlier pledge of support. The Fed also announced the opening of its Main Street lending facility enabling companies to borrow directly from the Central Bank.
N O T E W O R T H Y
Zombie apocalypse. Sounds kind of scary doesn’t it? No need to worry, you won’t need to wield a machete or a baseball bat to get through this one, just some common sense. Let’s start with yesterday’s market-driving news. Equity futures opened down in Asia on Sunday night unsurprisingly. A small uptick in new virus cases in Beijing caused the initial drag on equities. This, after a slight rise in US cases riled markets last week leaving many investors on edge. The Administration’s Larry Kudlow (usually a mainstay cheerleader on the plunge protection team) said that out-of-work Americans should not receive their $600 a week benefits but rather given a smaller bonus to return back to work. The markets read that as pullback of fiscal stimulus, which many argue is still not enough. Stocks had a rough start to the session but a statement by the Federal Reserve changed their course causing them to surge into the green for the close. Back in March, the Fed announced its Secondary Market Corporate Credit Facility (SMCCF). The facility would be used to purchase corporate bonds in the secondary markets in order to add liquidity and support the market. Since then the Fed has been buying bond ETF’s from BlackRock which then purchased bonds in the open market - normal for an expanding bond ETF. Yesterday the Fed announced that it would now begin to purchase bonds directly. The announcement spurred equity markets to rally, which is good, but what about the bond markets?
Bonds should be pretty straight forward. Companies use bonds to borrow from the public. Healthy companies pay less interest because they are less likely to default. Companies who are able to offer valuable collateral for bonds also pay less than those who offer a mere promise. When the Coronavirus crisis struck earlier this year causing an economic standstill, companies scrambled to make up cash shortfalls first by maxing out lines of credit and then turning to the bond markets to raise capital. As you might guess, if a company’s near-term health is in question, buying a bond from them would be a bit risky and one would expect there to be lower demand for those bonds. What that means for companies is that not only will they have to pay more in interest, but also that there may not even be enough buyers for those bonds. That was precisely the course of the bond market prior to the Fed’s initial March 23rd announcement in which they announced their bond buying plans. Suddenly-cash-starved companies had no efficient access to the credit markets… until the Fed stepped in. A surge in demand for bonds pushes prices up and yields down, keeping borrowing costs lower. Central bank buying also supports corporate borrowing by ensuring liquidity. That means there will always be a bid, or a buyer of bonds. Through tools like SMCCF and others, the Fed’s goal is to provide a safety net for corporations, and that has been accomplished… so far. Not surprising, bond issuance year-to-date has come at a record pace while yields spreads have tightened. Corporate bonds trade on spread to the treasury yield curve which serves as a reference point for pricing. Lower quality bonds are priced at bigger spreads making them cheaper, as you would expect. High demand for bonds tightens spreads, making them more expensive. It’s not just the Fed buying that is causing tightening of spreads. Bond buying has also surged beyond the Central Bank as investors are emboldened by a Fed backstop. Even the Fed’s announcement helped to tighten spreads prior to their purchasing a single bond in the market. So, it would seem that the Fed has accomplished what it has set out to do. For struggling corporations it means access to the credit markets at record low rates, which do not necessarily reflect the real level of risk taken on by investors. For investors, it may not end up so well.
Companies that are not financially sound have had access to the credit markets as a result of record low rates and tight spreads. The side effects of the borrowing means that an increasing number of unhealthy companies are spending all of their cash flows on making interest payments. Some companies can only afford to make interest payments but lack the assets to pay back the principal. When bonds are close to maturity those companies simply borrow more money to pay off the principal of the initial bond. With most of a company's cash being spent on interest payments, they are unable to invest in productivity and innovation… which is why lenders, in theory, invest in a company. Some companies debt service even exceeds their profits. These companies are referred to as Zombie companies, and their numbers are growing. Research estimates that Zombie companies could reach 20% of US corporations as a result of the pandemic crisis. Now, more than ever, it is critical for not just bond investors, but stock investors as well to look carefully at the financial health of a potential investment. Just because a stock is going up, that doesn’t mean it is healthy and can continue to return value. As with Zombies, you don’t want to let them get too close before you realize that you are in peril.
THE MARKETS
Stocks rose yesterday after the Fed announced that it would start buying corporate bonds directly in the secondary markets. The S&P 500 rose by +0.83%, the Dow Jones Industrial Average climbed by +0.62%, the Russell 2000 jumped by +2.30%, and the Nasdaq Composite Index traded up by +1.43%. Bonds went up on the news but 10-year treasuries pulled back adding +2 basis points to yield 0.74%. That means that spreads tightened, as described above. To see that visually, refer to Chart 17 in my attached daily chartbook.
NXT UP
- Retail Sales (May) are expected to have grown by +8.4% after falling -16.4 in April.
- Industrial Production (May) is expected to better by +3.0% compared to last month’s -11.2% fall.
- The NAHB Housing Market Index (June) may have risen to 45 from last month’s reading of 37.
- Fed Chairman Jerome Powell will address the Senate Banking Committee at 10:00 AM EDT.
- Fed Vice Chair Richard Clarida will speak this afternoon.
- Groupon, H&R Block, and Oracle will announce earnings after the bell.