Oh Borrow, Where Art Thou?

Malt Liquidity 93

Greetings from Miami, the home of every wannabe influencer and the birthplace of the “Forex lifestyle” meme. And apologies for the posting delay — I’ve been busy learning that the EM folks are the ones who have all the fun. Unfortunately, my Spanish is more likely to land me a predatory car lease than entry to the hottest clubs. Speaking of borrow costs, however…

The Rates are a-changin’

Previously, I’ve written about how

It’s seemingly contradictory that banks would struggle as rates rise, but investment banks are less lenders collecting a spread on offered vs internalized interest and more facilitators of debt-fueled transactions. In a higher rates environment, default probabilities for debt issuers are higher, which means that it’s harder to find buyers of that debt (as we looked at the other day, where you can totally take it on the chin on something like CVNA.)

It logically follows that companies are warier of tapping into debt markets as rates rise, dampening the demand for these debt-fueled transactions. Concurrently, credit ratings naturally matter more in riskier lending environments. If you’re a large borrower, would you rather risk your future borrowing capacity or find different methods of financing?

Borrowing costs have soared since the Federal Reserve started pushing up benchmark interest rates in an effort to curb inflation. Investors now demand annual interest payments of about 9 per cent a year from US businesses with low scores from rating agencies, up from just below 5 cent in March 2021. That punchy price tag means high-grade companies are steering clear of taking on extra debt to fund expansions or takeovers, instead relying more heavily on equity capital to keep their pristine ratings in place.

In a sense, this is counterintuitive — the point of building up credit is to utilize it to, well, borrow money. But debt liquidity is harder to predict now that the Fed is not backstopping the entire market. On an individual company level, if there is unsatiated demand, it makes sense to raise capital through equity instead, thereby offloading the risk of default and some volatility to shareholders.

…even safe, investment-grade companies in the US must pay an average of more than 5.7 per cent to borrow in the bond market, up from just 2 per cent two years ago.

It’s amusing that lenders are somewhat hesitating when yields are so high. Rates rising was fairly predictable — everyone knew that easy money wouldn’t last forever. I’d really like to find out who the parties were that issued debt like this to CVNA and their ilk:

Notes issued in 2020 coming due in 2028 at a 5.875% coupon… are trading severely underwater

Imagine running AAPL’s finances and having to source a borrow at 2020 CVNA rates! It’s like looking at Miami beachside condo sale prices from mid-2020 compared to now. The addiction to low rates has been somewhat weaned off of, but the memories (and track marks) remain.

Certainly this is more of an issue for lower-graded companies than AAPL — I don’t think any investor would pause for a moment to lend to them at a near 6% rate. But this is just another example that highlights why I believe that “rates are everything.” Whether it’s company M&A or assessing the viability of a trading strategy, cost of capital determines whether it’s even worth your time to put something into practice.

(C)ripple effects

Companies are not the only parties tapping debt markets — governments and countries consistently utilize these pathways to raise money (as one obviously cannot buy equity in the government directly), as I’ve noted before.

You might wonder why I even brought this [default] up, given that $150 million is a drop in the bucket for a developed nation with a debt to GDP of nearly 50%. However, think back to the discussion of contagion from a couple days ago — if one set of government bonds goes from the highest credit rating to junk status, why wouldn’t the rest follow? The illusion of a relatively risk-free rate gets shattered, and people start to clamor for their money.

Other than military actions, the most reliable foreign assassins of country stability are debt obligations that can’t be met. Serious questions emerge about the ability to maintain crucial operations that aren’t fiscally sustainable. Consequently, all correlated debt becomes unreliable — if the power utility can’t be funded, what about the other municipal bonds? As such, I took note of the current Puerto Rico situation:

Holders of Puerto Rico Electric Power Authority debt say they have a right to the utility’s future revenue. Prepa, as the agency is called, believes investors only have a claim to about $16 million in a sinking fund held by a bond trustee, just a sliver of the $9 billion the utility owes…

Traditionally, water and power utilities and authorities for highways, airports and transit systems have borrowed money with the pledge to repay their obligations from anticipated revenue to be collected over 20, 30 or even 40 years. A broad ruling against bondholder rights to future revenue would reshape that historic relationship.

A very simple model to differentiate debt vs equity is as follows: debt is a claim on stuff that already exists, while equity is a claim on what is expected to exist. Naturally, a lot of transactions mix elements between this dichotomy — a government body generally cannot sell equity in itself to lower the risk presented to the market, so debt products might contain a claim on forward revenue, as is present in this case. But a key difference between being a debt holder as opposed to an equity holder in the cap stack is the differing priority that capital and asset claims in the event of a bankruptcy — ignoring complications, debt holders get paid out before equity holders. However, there’s no money here — a laughable $16 million against $9 billion in obligations — and a government utility’s assets cannot exactly be distributed to private parties. Theoretically, a heightened interest rate is supposed to compensate for the potential risk. But the legal dispute here seems to revolve around whether the utility can work around terms created at the time of issuance:

US District Court Judge Laura Taylor Swain is reviewing the litigation. If she sides with Prepa and cuts bondholders off from future revenue, that could alter a long-standing precedent securing municipal debt backed by utility charges, special fees, toll revenue, sales-tax receipts and other similar pledges, especially those sold by risky borrowers.

The question seems to be regarding the validity of forward-revenue promises in a debt transaction. If deemed invalid, the very nature of all similar transactions could be completely shifted, severely shifting the actual risk of all these notes relative to what was calculated at the time.

Tom Moers Mayer, a lawyer for an ad hoc group of Prepa bondholders warned Swain during a Feb. 1 hearing that a decision to restrict bond repayment only to existing funds would wipe out all muni revenue debt undergoing court restructuring.

“That ruling would invalidate every revenue bond in this country under every Chapter 9 that will ever be filed,” Mayer said, referring to the bankruptcy process for cities, local governments and public entities.

A common misconception about legal edge is that it revolves around constructing creative, esoteric arguments designed to fit a thread through a tiny loophole, which ignores that the plain letter of the law and the intent with which it was created is generally enforceable. However, given the longer term nature of all these transactions — debt issuances are typically not products that resolve on a short time horizon — the potential for terms to be reinterpreted to be more favorable to one side or the other creates volatility that could be risk-efficient to trade amongst a swathe of products that already exist. Of course, going forward, all of these decisions add to the amount of coverage the lawyers will need to provide in the terms of any transaction. Still, it’s fascinating to see the interplay between capital markets and essential services — rates are behind everything:

Prepa is the main supplier of electricity to the Caribbean island and is one of the biggest US public power utilities by number of customers.

On that note…

I won’t delve into this myself, but this thread regarding who might have been behind Terra’s blowup was quite interesting.