Up and Down Wall Street
Why Are Stocks Rising? Bond Market Has Answer
Equities jumped 9% in two weeks, thanks to credit bounce. But debt can backfire, as energy sector shows.
By Randall W. Forsyth
Meanwhile, 70% of the biggest repurchasers have negative cash flow after buybacks, while 50% overall are in that position, which necessitates borrowing.
It was a Super Tuesday for the stock market, with U.S. shares gaining 2.5%. While that might be deemed as “huuuge,” politics had little if anything to do with the rally.
Give credit its due. The stock market’s recovery from its Feb. 11 lows has tracked the improvement in the corporate-debt market, especially the high-yield sector.
Credit spreads — the extra increment of yield to compensate investors for the risk of owning corporate debt securities over government debt — have been contracting for the past couple of weeks or so. That’s meant a concomitant rise in the prices of corporate bonds, especially the speculative-grade variety, and in turn, in equities.
The option-adjusted spread of the Bank of America Merrill Lynch High Yield index surged from 777 basis points (7.77 percentage points) to its widest level on Feb. 11 of 887 basis points, according to Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors. From there, the spread narrowed to 768 basis points by the end of the month.
The spread contraction resulted in a 4.24% total return in the last two-and-a-half weeks of February, more than offsetting the 3.85% plunge at the beginning of the month. And with the market’s rebound came a revival of flows into high-yield bond mutual funds. Lipper reported inflows of a robust $2.7 billion in the latest week ended Feb. 24, up from $65 million the previous week, which had followed three weeks of outflows.
In like fashion, U.S. equities are up nearly 9% from their Feb. 11 lows, which Wilshire Associates estimates added some $1.9 trillion to shareholders’ paper wealth, including $525 billion Tuesday.
Bespoke Investment Group observes that high-yield spreads have been breaking down on the charts, “and doing so in a big way.” (Remember, a breakdown in spreads or absolute yields is positive for bond prices.)
Indeed, the recent tightening in the CDX HY Index of credit-default swaps on high-yield names has been the biggest (some 48 basis points in the past five sessions) since last October.
This reversal has helped support equity prices in the U.S. and Europe, B.I.G. analysts write. “If high yield can sustain its rally, it’ll mean a big sigh of relief for corporate treasurers and investors around the country,” they conclude.
As for the former cohort, treasurers and chief financial officers are hugely dependent upon the credit markets, most notably to finance buybacks of their common stocks. But, as the late economist Herb Stein famously observed, something that can’t go on forever, won’t.
Stock repurchases have been a major driver of the bull market, most of which has been financed by borrowing. “Debt-funded buybacks can only continue if the credit market cooperates,” writes Barclays equity strategist Jonathan Glionna.
According to the bank’s data, companies in the Standard & Poor’s 500 have spent some $2.5 trillion on buybacks since 2010, which has been a big contributor to the bull market, he continues.
“When cash flow declines and the debt markets curtail funding, buybacks stop,” Glionna says. The energy sector is a good example of what can happen. Indeed, the process has gone into reverse with companies such as Marathon Oil and Weatherford International resorting to equity financing to shore up their balance sheets — despite depressed stock prices.
For now, the investment-grade corporate bond market remains open to top names, such as triple-A-rated ExxonMobil, which made a massive $12 billion bond offering earlier this week to support its stock repurchases. Apple also has slated another $10 billion-$12 billion in borrowing to fund buybacks while avoiding repatriation of its cash hoard held outside the U.S.
The revival of the high-yield market also allowed hospital-operator HCA to come to market Tuesday with $1 billion of 10-year notes. (HCA actually is rated triple-B-minus, the lowest rung of investment grade, by Standard & Poor’s, while Moody’s Investors rates the hospital chain one notch lower into junk territory at Ba1.) While HCA said the proceeds were for general corporate purposes, KDP Investment Advisors pointed out in a research note that HCA has been an active stock repurchaser.
While there’s a limit to this financial engineering when spreads widen enough to make borrowing too expensive, that hasn’t happened yet, Glionna concludes.
Still, the action in the credit and equity markets in the past few weeks clearly shows their interdependence.