May 2016 – Monthly Commentary

May 2016

Investors were left bewildered with the release of the employment report on June 3 when the Bureau of Labor Statistics reported that the economy added a paltry 38,000 jobs in May, far below the 160,000 new jobs economists had been expecting. Adding to the disappointment was the 37,000 downward revision to the prior month’s report. What’s perplexing is that the government measure is at odds with the private employment report tallied by the ADP Research Institute. That report typically precedes the government report by a day or two every month, with the two registering a correlation to each other in excess of 90%. Given that ADP reported a gain of 173,000 for the month and a 10,000 job upward revision to the prior month, it seems likely something skewed the BLS report to the downside. The government report is also at odds with other measures of job growth including the JOLTS job openings report, the weekly unemployment insurance report, and the various regional surveys. With that, we’ll look to the next report for further clarification on the health of the job market. Certainly the report all but rules out the chance of a rate hike later this month when the FOMC meets. While recent data has clearly shown an uptick in activity versus the first quarter of this year, the employment report is enough to keep the Fed from acting. FOMC members will also release their economic forecast at the conclusion of the meeting, which will offer insight into their thoughts on economic growth and monetary policy. Although, we ask ourselves what good is that insight given that they haven’t put forth an accurate forecast since they began the exercise four years ago.

Several months ago we wrote about contingency capital bonds and how the risk/reward balance is skewed against investors. As we explained, if the balance sheet of an issuing bank deteriorates in a predetermined manner, the principal of the bond is converted to equity. We say skewed because as investment grade bond investors, we expect to earn a rate of interest for a nearly non-existent probability of default. The contingency structure promises a rate of interest with the possibility of a number of loss inducing outcomes. That doesn’t comport with our definition of investment grade. Credit Suisse last month issued a bond which performs in a similar manner to a contingency capital bond. The new issue is known as a catastrophe “cat” bond. In this particular cat bond, principal would be extinguished if the bank suffered a loss in excess of $3.5 billion. To give bond investors some protection, any single catastrophic loss would be capped at $3 billion. Therefore, the bank would need to suffer at least two catastrophic losses totaling more than $3.5 billion to trigger the extinguishment. What’s especially vexing is that included in the list of qualifying catastrophes is insufficient internal controls, errant systems, and most egregious, rogue trading. In effect, buyers of the Credit Suisse bonds are on the hook to guarantee the bank against losses from everything from corporate malfeasance to a “fat finger” trading mistake.

Another example of the perils of ultra low interest rates is Dell Corporation’s recent bond deal. Recall that three years ago Michael Dell, Blackstone Group, and Carl Icahn were involved in a bidding war for the company. Michael Dell, along with Silver lake partners, ultimately prevailed and paid $24.9 billion for the entire company. The transaction seemed to be a risky one given the declining sales of personal computers, the bread and butter of Dell. Nonetheless, the company was able to finance the purchase with a massive bond sale. Dell, which has operated as a private company since the takeover, came to market again last month with another massive deal. This time the funding was to finance its acquisition of EMC Corporation, the network storage company. The six part deal was met with enthusiastic demand with dealers tallying $85 billion in orders for the $20 billion in issuance. The new issues are rated BBB-, just one notch above junk bond status. While the company paid an above market rate of interest for the notes, we worry that the compensation was not enough for the risk assumed by investing in a privately held corporation, especially a highly levered one. Should the company sustain a downgrade, we anticipate that many investment grade funds would be forced to sell. Given the size of the issuance, less liquid nature of the Junk market, and Dell’s overall interest burden, we could envision a scenario where the price of Dell’s debt plunges.