The U.S. Fed’s unprecedented market interventions was recently on display. If you are trying to work out why there is such a difference between Main Street and Wall Street, the example below may provide some clues.
As of 12 May 2020, the U.S. Fed has started to purchase ETFs as part of its emergency program known as the Secondary Market Corporate Credit Facility (see below), which we have previously written about in our weekly credit report and in our multi-asset strategy quarterly. Part of these purchases have included high yield ETFs, which hold the bonds of Hertz Global Holdings Inc (HTZ). You may have seen the news recently that Hertz has filed for bankruptcy in the U.S. Bankruptcy proceedings in the U.S. can be drawn out and complex, but there is a chance the U.S. Fed could end up holding equity in Hertz as part of some restructure. We are not entirely sure the U.S. Fed’s playbook has a strategy to deal with this type of outcome.
The U.S. Fed’s positions disclosed. Whilst the bulk of the U.S. Fed’s ETF purchases are geared towards investment grade, the Fed also purchased high yield ETFs including iShares iBox High Yield Corporate Bond ETF (HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK). Both ETFs hold the bonds of Hertz Global Holdings Inc (HTZ), which has around US$20.6bn in debt. The table below provides U.S. Fed’s disclosures of its ETF purchases.
Source: U.S. Federal Reserve
Background: As we have previously published, the U.S. Fed set up several key initiatives to combat COVID-19:
(1) Secondary Market Corporate Credit Facility (SMCCF) with an initial size of US$250bn. The Fed will purchase non-bank corporate bonds in the secondary market which are rated Baa or higher, with remaining maturities of 5 years or less. Further, the facility will also buy Ba-rated bonds if they were downgraded after March 22 – that is, fallen angels. The facility will also buy investment grade ETFs (iShares iBoxx Investment Grade Corporate Bond ETF) and some high-yield ETFs (iShares iBoxx High Yield Corporate Bond ETF). They will limit owning a maximum of 10% of any firm’s debt and owning a maximum of 20% of any ETF.
(2) Primary Market Corporate Credit Facility (PMCCF) with an initial size of US$500bn. The Fed will purchase newly issued non-bank corporate bonds in the primary market issued at Baa or higher, with maturity of 4 years or less. The Fed will buy Ba-rated bonds if the issuer was downgraded after March 22. Part of the deal will allow firms to borrow up to 130% of outstanding debt. What this means is that investment grade firms can refinance all debt and be able to take on additional debt. Firms can use proceeds from new issuance to refinance existing obligations.
(3) Main Street New Loan Facility (MSNLF) and Main Street Expanded Loan Facility (MSELF) with an initial size of US$600bn. The facility will purchase 95% of eligible loans from the banks. This will allow the banks to free up more capital which can be recycled back into the economy. Eligible new loans must keep borrower’s debt-to-EBITDA below 4.0x. Eligible expanded loans must keep borrower’s debt-to-EBITDA below 6.0x. Loans cannot be used to refinance existing obligations.
Hertz is no small company. With a 100 year history, Hertz is one of the U.S.’ largest car rental companies and a global brand. According to Bloomberg, the Company has debt of around US$20.6bn on its balance sheet and due to COVID-19 approximately 700,000 cars are not in use. However, Hertz troubles are not all down to COVID-19, it has been facing stiff competition from other car rental companies, but also from disruptors such as Uber and Lyft. This has seen Hertz adjusted net income fall from US$293.8m in FY11 to US$81.4m in FY19.
Potentially more to come? As of 28 May-20, iShares iBox High Yield Corporate Bond ETF (HYG) had over 1,000 positions (including Hertz). How many more could potentially file for bankruptcy in the coming months?
What is the take away from Hertz experience? The U.S. Fed (or any central bank for that matter) can continue to pump liquidity into companies and create easy financial conditions (including refinancing), but the Fed cannot improve a company’s operating cash flows and revenue. Invariably only the strong business models will thrive (or at least survive) in the end.
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Investment Manager / Director at BanyanTree Investment Group
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