When I hear “Ponzi” I think of Pyramids, Fraud and Financial Loss. Recently I read more about the “Minsky Moment” and the stages of a financial bubble. To bond holders and lenders the definition of “Ponzi” stage may sound eerily familiar.
What strikes me is that when we use the Ponzi label we sit up and take note, it is off-putting, it curbs our enthusiasm. It is a red flag waving alarm bell of monster proportions. And yet we could all probably think of borrowers who have managed to tick the definitional boxes associated with the Ponzi phase of the bubble.
Before we get started this post is inspired by Jamie Catherwood’s Investor Amnesia Blog. For those of you who don’t know him he is a super talented guy whose posts on Finance through history that entertain, educate and elucidate. I highly recommend that you subscribe to his “Sunday Reads” – recent posts cover Oil, Pandemics and Minsky Moment’s.
High Yield – “Speculative Grade” carries an inherent amount of risk – typically borrowers can be small in size, at one end of the growth cycle within an industry – new or declining, belong to a growth industry or be large in size but choose to have a levered capital structure. High yield lending is an essential part of any economy – any walk around a town or city will exposure to 10’s to 100’s of High Yield Companies – Telco, Cable, Auto,Retail, Restaurant’s, Services, Steel, Cement, etc, etc.
At the heart of Minsky’s work is the idea that periods of economic stability breed speculation and risk taking. Emboldened by this, investors, institutions and governments taking on increasingly large amounts of debt to fund growth, increase returns and speculation starts. For High Yield borrowers the last decade has been an extremely stable period with Central Bank “puts” providing rivers of liquidity and low financing costs. This has been accompanied by increasingly loose covenant’s, riskier capital structures and higher leverage multiples.
Fast Forward to today – heightened uncertainty and unprecedented central bank action to stave off the devastating effect of Covid-19. Now Borrowers find themselves in a situation where “growing” themselves out of a highly levered capital structure is looking difficult without a return to normality, calling or maturing debt early on the basis of being able to refinance existing debt at lower rates is not a given. Operating leverage and liquidity are the main concerns.
Mr Catherwood’s post breaks down the 3 types of financing identified by Minsky:
- Hedge Financing (Safest): ‘Firms rely on their future cashflow to repay all their borrowings. For this to work, they need to have very limited borrowings and healthy profits.’
- Speculative Financing (Riskier): ‘Firms rely on their cashflow to repay the interest on their borrowings but must roll over their debt to repay the principal. This should be manageable as long as the economy functions smoothly, but a downturn could cause distress.’
- Ponzi Financing (Dangerous): ‘Cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed.’
So “Ponzi Bonds” ?
High Yield investments have speculative component’s – the most common component – in recent years is that borrowers ‘must roll over their debt to repay the principal. This should be manageable as long as the economy functions smoothly, but a downturn could cause distress.’ . Clearly the economy is not functioning smoothly. Government’s are providing bridge loan’s to companies allowing them to avoid a liquidity crunch. Borrowers on a return to normalization, at the higher quality end of the high yield spectrum, will be able to keep on rolling their debt. Riskier companies will also be able to roll their debt, but at a cost. Near term bond maturities will carry extra risk and being able to assume Mr Market will be there to facilitate refinancing is not be a given. Over time though, normality will resume.
Recently companies have managed to secure lifeline funding from the market by pledging security on assets, sometimes necessarily subordinating existing bondholder claims in the process. The “Ponzi Bond” label is appropriate for some of issues as borrowings only cover operational cash flows 6 months or so out into the future.
Investors will argue that the interest rate paid by these companies is “cheap”, that the security more than covers the principal. Skeptics will counter being able to put a price on anything under current conditions is impossible, today’s buyers are probably not the type to hold an investment through a restructuring and security is only worth what others are willing to pay.
There was a behavioral study in which people were served soup, as the soup was being served the server would take a brand new toilet brush out of its plastic wrapper and stirred the soup. The Soup was then served to the test subjects. Despite the toilet brush being brand new and clean, unsurprisingly, no one ate the soup.
It is the same with labeling. “Ponzi Bonds” is the toilet brush in your soup.
When that new issue comes, pause for thought, think of Minsky.
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