Junk Glistens Under ‘Bernankecare’ as Worst Stocks Win
Carl Giannone says he’s given up hunting for quality stocks. Now he’s simply riding the wave of upward momentum in the U.S. market.
“It’s a game of musical chairs,” said Giannone, who manages an equities team at T3 Trading Group LLC in New York. “You just want to make sure you can sit down.”
The Federal Reserve’s near-zero interest rate turns five years old next month, the longest period without an increase in history. Coupled with more than $3 trillion of asset purchases, it adds up to “Bernankecare,” said Joshua Brown, chief executive officer of Ritholtz Wealth Management in New York. And it’s causing parts of the market to behave strangely. Stocks of companies with weak balance sheets are rising twice as fast as stronger ones; junk borrowers get rates lower than their investment-grade counterparts did before the credit crisis; and initial public offerings are doubling on their first day of trading.
While in the minority, some investors say prices have climbed so high it’s possible to look ahead and see an ugly end. Laurence Fink, chief executive officer of BlackRock Inc., the biggest U.S. money manager, said in an interview with Bloomberg Television on Nov. 12 that he feared a bubble and the Fed ought to quit buying so many securities.
“At some point we’ll have to pay the price of this,” said Michael Shaoul, chief executive officer of Marketfield Asset Management LLC in New York. Among the woes Shaoul foresees: “higher inflation, higher interest rates, much more difficult business conditions.” But it’s a long way off. “I would be very surprised if this bull market ended sooner than 18 months, and maybe it’s 36 months,” Shaoul said.
The Standard & Poor’s 500 Index has rallied almost 26 percent in 2013, on pace for its best yearly gain in a decade. Futures on the index expiring in December were down less than 0.1 percent at 1,787.50 at 9 a.m. in New York.
Almost everything in the equity market is rising, which worries Jamie Potkul, chief investment officer of the Bread & Butter Fund. About 450 stocks in the S&P 500 are up this year, making it the broadest rally in at least two decades. That’s left investors with fewer buying opportunities than during the technology bubble in 2000, when the rally was propelled by an ever-shrinking pool of dot-com stocks, Potkul said.
At the same time, investors are awarding some of the highest valuations to companies that have struggled to produce consistent profits. Amazon Inc. (AMZN) trades at about 1,300 times reported earnings. Netflix Inc. is valued at 197 times income and Consol Energy Inc. has a price-earnings ratio of 104.
A Goldman Sachs index of companies with weaker balance sheets has rallied 42 percent this year, almost doubling the gain in a measure of more creditworthy firms. The New York-based bank uses a formula originally developed to forecast bankruptcies to put together the baskets.
The gauge of 52 firms with weak balance sheets includes stocks such as:
-- Tenet Healthcare Corp. (THC), which has the highest debt-to-equity ratio among health companies in the S&P 500. The shares have rallied 29 percent in 2013 and increased more than 1,000 percent since the bull market began in March 2009.
-- Micron Technology Inc. (MU), which more than tripled its total debt since 2011 to ten times annual free cash flow. The stock has surged 204 percent this year.
-- Hewlett-Packard Co. (HPQ), which has boosted total debt three-fold since 2007 while earnings have been flat. The stock, which just three of 36 analysts recommended buying at the end of last year, is up 75 percent in 2013.
“The analysis at some point shifts from fundamentals to being purely based on the price action of the stock,” said Michael Purves, chief global strategist at Weeden & Co. in Greenwich, Connecticut.
Gains are brisk in initial public offerings. Twitter Inc. jumped 73 percent in its trading debut this month, delivering the biggest one-day pop for an IPO that raised more than $1 billion since Alibaba.com Ltd. made its debut in 2007, according to data compiled by Bloomberg. The unprofitable messaging service has a market value above $23 billion.
Potbelly Corp. (PBPB), a Chicago-based casual restaurant chain, and Container Store Group Inc., which sells storage products, doubled on their first day. Last week, Facebook Inc. offered to pay about $3 billion for Snapchat Inc., which makes a mobile photo application, according to a person familiar with the matter. It was turned down.
If Giannone’s musical chairs analogy is reminiscent of former Citigroup Inc. Chief Executive Officer Charles O. Prince’s July 2007 declaration that “as long as the music is playing, you’ve got to get up and dance,” consider that subprime loans, given to people with little proven ability to pay, are making a comeback, this time to buy cars. Issuance of bonds linked to loans for the shakiest borrowers hit $17.2 billion this year, more than double the amount sold during the same period in 2010, according to Harris Trifon, a debt analyst at Deutsche Bank AG. The market peaked at about $20 billion in 2005, he said.
Not every hallmark of the credit crisis is reviving. Financial innovations such as collateralized debt obligations that bundled subprime mortgages -- and which helped hasten Prince into retirement later in 2007 -- have all but disappeared.
Fed largesse, however, has saved the lives of subpar companies such as Avon Products Inc., RadioShack Corp. and J.C. Penney Co., which wouldn’t have survived without cheap loans and the Bernanke-goosed boost to their stock prices, said Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP, which manages about $53 billion.
Yields on dollar-denominated debt rated below BBB- at Standard & Poor’s have dropped below 6.5 percent, the same level as investment-grade bonds the week before Lehman Brothers Holdings Inc. failed, Bank of America Merrill Lynch index data show.
“With zero-interest-rate policies, you put the conditions in place for everybody to be a winner,” Baha said. “You’ve had a five-year period of government policies that have allowed companies to thrive when the free market would have allowed them to fail.”
There’s too many winners for Howard Marks, chairman of Los Angeles-based Oaktree Capital Group LLC, the world’s largest distressed-debt investor. Marks has made a fortune buying bonds of companies that have defaulted or gone into bankruptcy and selling them for more than he paid.
Bernanke’s policies made those opportunities scarce in distressed “and every place else,” Marks said in an interview. “There’s a lot of money around, people are risk tolerant and the capital markets are generous,” he said. The defaults you’d see in a normal environment haven’t happened, because rates are low, refinancing is cheap and easy, and investors are too complacent to push for debt protections, allowing companies to forgo standard safeguards and sell what are known as covenant-lite bonds and loans, according to Marks.
“I’m not ready to blow the whistle and say ‘everybody out of the pool,’” he said. “But sometime around 2010, they became risk tolerant, and risk-bearing returned to the market. When others are bearing risk, we have to be careful.”
The rate of junk defaults globally fell to 2.8 percent last month, compared with the long-term average since 1983 of 4.7 percent, according to Moody’s Investors Service.
Bond investors are lending money without the traditional backstops. Companies issued $257 billion of covenant-lite loans this year as of Nov. 4, compared with $7.7 billion in 2009, according to data compiled by Bloomberg.
Typical loan protections have also weakened by allowing companies to change the way leverage, or the ratio of debt to earnings before interest, taxes, depreciation and amortization, is calculated, making it easier for a borrower to comply with covenants.
Bonds rated CCC or lower -- at least eight steps below investment grade -- by S&P have gained 11 percent this year, compared with about 6 percent gain for all dollar-denominated junk bonds or a loss of more than 1 percent for investment-grade debt, according to Bank of America Merrill Lynch index data.
Debt that’s rated BB -- two grades below investment quality -- may be even more specious, said James Serhant, head of high yield at Hartford Investment Management Co. in Connecticut. The $516 billion of dollar-denominated notes included in the top tier of junk are trading at an average price of more than 104 cents on the dollar.
“You’re going to buy those in the mid-80s,” Serhant said, referring to the junk notes with the lowest coupons and the most sensitivity to rising interest rates. Right now, “it’s a relative game.”
Charter Communications Inc. (CHTR), the cable operator that exited bankruptcy in 2009, sold $1 billion of bonds in April that yielded 5.75 percent, about the same as the yield on a 10-year Treasury note at the end of 2000. Hilton Worldwide Inc., which was the subject of a $26 billion leveraged buyout by Blackstone Group LP in July 2007, sold $1.5 billion of 5.625 percent bonds in September.
For Jonathan Berger, who founded long-short credit hedge-fund firm Birch Grove Capital LP with more than $300 million in capital, the whole rally since 2009 has been uncomfortable since Fed stimulus could be curbed in a process now known as tapering at any time.
“You never feel certain,” he said in an e-mail. “It wasn’t just a linear trajectory from 2009 to today. There was significant volatility along the way and I would imagine we will continue to see volatility for the foreseeable future.”