October 2019

Last month we wrote of the technical hiccup in the Repo market, the financing mechanism Wall Street utilizes to borrow money to pay for securities.  We identified it as a symptom of too much government borrowing as the U.S. runs wider and wider deficits.    To reiterate, the repo market is a little-followed, but important cog in capital markets.  We also wondered what the government would do about the problem to avoid having it develop into a financial panic. The Fed was quick to answer that question.  In addition to participating in daily overnight repo, they have reinstituted longer term repo operations and we anticipate that they will ensure that financing in that market is secured before the last day of the year.

Earlier this month, private equity firm KKR announced a bid to take the Walgreens Boots drugstore private in a leveraged buyout, and issue a mountain of debt to finance the purchase.  Prior to the announcement, the BBB-rated Walgreens 4.40% 9/15/42 notes were trading at an incremental spread of 205 basis points above Treasury notes, which translated into a price of about $102.40 and a yield to maturity of approximately 4.25%.  After the news hit, the spread widened and the price fell to $96.00.  In the course of a single day, an entire year’s worth of income, and some of the next year’s income was wiped out.  Consensus on the Street is that to close the deal, KKR will need to float more than $50 billion in new debt.  Should the deal proceed, the rating is likely to fall to junk bond status and the price of the 4.40% issue is likely to fall further.  This instance is a direct consequence of artificially low interest rates.  Because of the heightened appetite for yield, investors are pushed into riskier investments that offer little protection in the event of a negative credit event.  Moreover, with ultra-low interest rates, the cost to KKR of doing such a deal is attractive when viewed historically.  This is exactly what has been driving the corporate stock buybacks for the last decade. 

Ironically, the Federal Reserve in its latest financial stability report cited “elevated asset prices and historically high debt owed by U.S. businesses” as top vulnerabilities posed to the U.S. financial system.  The report was specifically warning about the $1.1 trillion sub-investment grade junk bond and levered loan market.  The Fed’s concern is that when the U.S. economy ultimately contracts, the leverage could create a vicious circle of risk unwinding.  We believe that risk isn’t limited to sub-investment grade.  The aggregate credit quality of the investment grade universe has deteriorated as well.  After more than a decade of selling debt to buy back equity, balance sheets have become more levered, with some BBB-rated credits already sporting financials that should have them downgraded to junk.

The good news is that for the foreseeable future the Federal Reserve will back-stop any and all signs of financial stress with their balance sheet via expanded repo operations and open market Treasury purchases.  However, it doesn’t take a mathematician to understand that if the government is going to need to finance a 1.2 trillion-dollar deficit, year after year, then the Fed’s job of plugging holes in the bond market is going to get bigger, not smaller.

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