Novum Alpha - Daily Analysis 24 June 2021 (10-Minute Read)
In a week devoid of major macro news, markets moved more or less sideways as investors sought to divine any clues as to U.S. Federal Reserve policy in the coming months.
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A terrific Thursday to you as markets turned choppy towards the end of the week.
In brief (TL:DR)
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In today's issue...
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Market OverviewIn a week devoid of major macro news, markets moved more or less sideways as investors sought to divine any clues as to U.S. Federal Reserve policy in the coming months.
Volumes were muted as investors sat mostly on the sidelines and while U.S. Federal Reserve Chairman Jerome Powell assured markets that the Fed wasn't about to raise rates anytime soon, other Fed officials who vote on the topic are due to speak this week and may suggest otherwise.
Asian markets were more or less stable heading into Thursday with Tokyo's Nikkei 225 (+0.12%), Seoul's Kospi Index (+0.36%) and Hong Kong's Hang Seng (+0.31%) up in the morning trading session, while and Sydney’s ASX 200 (-0.17%) was down slightly.
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1. Capitalizing Communist China Could be Costly
After over a decade of loose credit conditions and copious amounts of risk taking, China is making the painful transition to let the chips lay where they fall.
Whilst giant government-owned or linked conglomerates had gone on shopping sprees, gorging on cheap debt to fuel glitzy asset purchases, often times overpaying for overseas acquisitions, Beijing has had to stump the bill for that profligacy, bailing out ailing state-owned companies in the process.
In a nationwide campaign to cut leverage and instill corporate discipline, China’s massive US$12 trillion credit market is starting to feel the pinch.
And “too big to fail” may not necessarily apply to Chinese government firms, as a record US$23 billion worth of debt or more is expected to go into default this year.
Taking advantage of a strengthening economy, Beijing is looking to stabilize its financial markets and build resilience in the corporate sector, after years of using the stock and bond markets like a casino to enrich institutional and retail investors alike.
The fallout is likely to result in pain for big conglomerates that had taken on massive amounts of debt to recklessly expand to dangerous sizes that pose a threat not just to the financial system, but Chinese President Xi Jinping’s iron-fisted rule as well.
But President Xi is caught between the Charybdis of allowing the markets to self-sort winners and losers, and the Scylla of undermining investor faith in government guarantees.
And to be sure, the dilemma is not unique to President Xi either, with his predecessors having to decide whether to allow indebted giants like China Huarong Asset Management (-1.92%) and China Evergrande Group (+4.40%) to face the music, making the financial system more resilient in the long run, but causing significant short-term pain and potentially roiling markets.
Beijing may have grown an appetite to allow even important regional state firms to fail, but allowing China Huarong Asset Management and China Evergrande Group to default may be a bit too much to swallow, given their size and significance to the entire system.
With its centenary celebration just a week away, the Chinese Communist Party may be running out of time, and officials are warning that last year’s monetary and fiscal stimulus pushed leverage to record levels, which may be destabilizing for the entire economy.
Part of the problem of course is that Chinese corporate debt is denominated in dollars and what the U.S. Federal Reserve does to interest rates has profound impact on the other side of the Pacific.
While Beijing is expected to intervene should a credit crisis occur, there is considerable uncertainty over the extent and speed of such support.
China Evergrande Group, a massive property developer, is nursing US$100 billion of debt and selling assets to cut its debt burden, even as Fitch Ratings has cut its bond rating to junk.
China Huarong Asset Management is in even worse shape, with US$39.8 billion in outstanding borrowings, the company failed to release its 2020 earnings in March and some of its longer-dated bonds are trading at stressed levels.
So far, Beijing has dealt with corporate conundrums the way you’d expect – China Huarong Asset Management’s former chairman was executed this year on bribery charges.
But there are just so many executives that you can put before a firing squad or send to the gulag, and at some point, either the debt gets paid or these companies go into default.
Beijing’s stony silence on the China Huarong Asset Management debacle is deafening, but a collapse of either company has the potential to deafen the entire Chinese economy.
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2. What Type of BuzzFeed Investor are you?
With viral quizzes like which “Friends” character are you and clickbait headlines, BuzzFeed has created a name for itself in the cutthroat digital media market and now it’s looking to carve a name for itself in the capital markets.
By way of a special purpose acquisition company or SPAC, BuzzFeed’s listing is to better position itself to compete for online ad dollars against the likes of Google (-0.17%) and Facebook (+0.46%), which hoover up ad revenue by leveraging user-created content.
As a content generator, BuzzFeed faces the same set of challenges that all other content creators have to deal with – platform providers still get most of the spoils.
And even as BuzzFeed has grown, using acquisitions along the way, the dominance of Google and Facebook has only increased, with even Australia throwing in the towel when it threatened to ban Google after the search giant got into a dispute with major local news networks.
Which may explain why BuzzFeed is looking to grow outside of purely content creation, including e-commerce and affiliate marketing – the practice of making money by selling or referring potential customers to websites that sell products they might be interest in.
BuzzFeed’s foray into these other businesses may be challenging, especially in an increasingly crowded market and Amazon's (-0.05%) overwhelming presence in the affiliate sales and marketing business.
Even with the funds raised from a prospective SPAC, there is no guarantee that BuzzFeed can enlarge its share of the digital ad sector, with the bulk of growth going to Google, Facebook and Amazon, a trend that has only proved more durable in the wake of the pandemic.
And BuzzFeed has struggled in recent years to gain traction.
In 2017, BuzzFeed missed revenue targets of around US$350 million by as much as 20%, and was forced to lay off about 100 employees, mainly in advertising sales and business operations.
And while BuzzFeed was profitable in 2020, the first time since 2014, it was said that most of those profits were generated by cutting some US$30 million in expenses.
That said, BuzzFeed still generates plenty of quality content outside of catchy quizzes, clinching the coveted Pulitzer Prize for international reporting with articles that revealed efforts by the Chinese government to detain Muslims.
And last November, the company announced that it was buying the acclaimed Huffington Post from Verizon Communications (-0.53%) in a stock deal for an undisclosed amount.
But a BuzzFeed SPAC is unlikely to generate the buzz in capital markets that the media company may be looking for.
SPAC interest has waned as the U.S. emerges on the other side of the pandemic and an estimated 80% of SPACs are now well down from when they were launched, with investor interest declining.
BuzzFeed operates in a challenging landscape which has seen content platforms hold almost all the leverage over content creators, and will need to contend with other media outlets like VICE News.
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3. No Bitcoin ETF? How about MicroStrategy's Bitcoin Bonds?
For as long as institutional investors have been trying to participate in some sweet Bitcoin action, there have been costly vehicles to provide them a pathway to do so.
From Grayscale Investment’s Bitcoin trusts to the CME’s (-0.50%) cash-settled Bitcoin futures, institutional wrapping comes at a premium.
But short of a U.S. Bitcoin ETF, investors have had to pay a premium for institutional-grade Bitcoin, to avail themselves of all the institutionally-required bells and whistles to keep compliance departments happy.
And with MicroStrategy well on its way towards re-inventing itself as a Bitcoin proxy from a enterprise software company, the bigger question on Wall Street is why not just buy Bitcoin outright instead of buying a Bitcoin junk bond?
Yet despite Bitcoin dipping below US$30,000 momentarily before tacking back up again amidst a Chinese crackdown on Bitcoin mining, MicroStrategy had no difficulty selling US$500 million of junk bonds to fund its Bitcoin purchases, up 20% from its initial target sale of US$400 million.
And who was buying MicroStrategy’s bonds?
Hedge funds, which had a solid presence and snapped up MicroStrategy's Bitcoin junk bond offering well ahead of its official launch.
At least some of the demand for MicroStrategy’s junk bonds came from institutional investors who were craving for Bitcoin exposure, but couldn’t buy the cryptocurrency outright because of how their funds are structured.
And with U.S. regulators kicking the bucket down the road on whether to approve a Bitcoin ETF, which would trade on exchanges just like any other stock, institutional investors aren’t left with a whole lot of choice.
But like ETFs, corporate debt (even if it’s used to buy Bitcoin) is fair game for a wide range of institutional investors.
Yet these institutional investors buying into MicroStrategy’s Bitcoin junk bonds may be selling themselves short.
While MicroStrategy’s Bitcoin junk bond offering yields upwards of 6% for a 7-year note, it’s not even a rounding error in the 5,500% increase in value that Bitcoin has enjoyed over the past 7 years.
Investors have to know that lending money to MicroStrategy to buy Bitcoin isn’t the same as actually buying Bitcoin – the issuer gets all of the upside (and downside) of the underlying asset.
Buyers for MicroStrategy’s offering were drawn to the downside protection baked into secured bonds – provided the software firm doesn’t abandon its existing business and maintains positive cashflow, there’s also the intellectual property from the software, with Bitcoins purchased that have huge upside potential that make it easy to assess the risk of losses from investing in the bond.
While Bitcoin is now just over half of what it was worth in mid-April, investors will get a 6.125% coupon on the MicroStrategy bond which can’t be repaid early for the first three years.
Guaranteeing that new debt will be the Bitcoin that MicroStrategy intends to buy, but not the company’s existing hoard.
MicroStrategy’s bond could make sense for high-yield bond investors who believe in the fundamentals of the company’s software business (whatever those are) and even a hedge for those long on Bitcoin or the company’s equity.
And at current prices, even a punt on MicroStrategy’s stock might not be altogether unwise, given that it is down by around half from its most recent high, but is not without risk.
If Bitcoin falls too much, MicroStrategy may need to refinance its existing convertible notes with traditional debt, driving up leverage at the firm to 19 times based on its existing debt of US$2.2 billion against EBITDA (earnings before interest, taxes, depreciation and amortization) of just US$115 million.
According to S&P Global Ratings, MicroStrategy will need to do a distressed debt exchange before its convertible note matures if Bitcoin drops below US$6,000 – unlikely, but not entirely impossible.
But with each additional Bitcoin-based bond offering, MicroStrategy provides institutional investors something that the U.S. Securities and Exchange Commission hasn’t – a backdoor to Bitcoin exposure.
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Jun 24, 2021