- Investors may evaluate opportunities to buy a firm’s equity or liabilities in isolation, rather than reviewing the full capital structure of the issuer.
- Discrepancies between market prices across that capital structure can signal market malfunction, arbitrage opportunities or something else entirely.
- We present a case study of Hertz’s recent bankruptcy filing, which may suggest that credit investors viewed potential equity sales as a bailout from equity investors, though not one that would make them whole.
The importance and subtleties of firms’ capital structures have been revealed to investors by the depth and magnitude of the COVID-19 crisis. The capital structure of a firm refers to the composition of its mix of assets and liabilities, and these different ownership claims are often evaluated in isolation from one another. However, when viewed holistically, the market’s prices for an issuer’s bonds may contain valuable information regarding its leveraged loans or its equity, as they provide insights into the debtholders’ expectations for the possibility of the firm’s default probability and recovery rates.1 As COVID continues to drag down even well-positioned firms, investors might take heed of all the information the market contains about their portfolios.
Bankrupt Bonds Rallied on Equity Euphoria
Source: IHS Markit, MSCI
Hertz Global Holdings Inc. provides a timely case study of how connecting the dots across markets can help investors understand issuer-level turbulence. The convulsions of Hertz’s equity price throughout the summer of 2020 suggest that some equity investors were unaware of bondholders’ recovery expectations. The equity rally in early June (emphasized in the exhibit below) took place while holders of Hertz bonds and credit-default swaps were expecting losses as high as 90% during default. However, the equity rally was then followed by an upswing in recovery expectations. Since Hertz debtholders would be entitled to any funds the company were to raise in an equity sale, the rally in market-implied recoveries may have been a reaction to the equity appreciation, a possibility only visible by evaluating the issuer’s entire capital structure. This strange state of affairs nearly led to an unprecedented public-equity offering by a company in the throes of bankruptcy protection.2
Equity Prices in the Eyes of Bondholders
Source: IHS Markit, MSCI
The price dynamics of securities across Hertz’s capital structure may suggest that credit investors viewed such an offering as a potential bailout from equity stockholders, though not one that would make them whole. Nimble investors aware of this brief disconnect between the equity and debt markets could have used this information to their advantage, liquidating their bond positions at a higher price. A holistic approach, which includes an analysis of different asset classes and subordination types, may help distinguish zero-sum investments from value creation.
1Recovery rates represent the expectation of bondholders’ recovery of interest and principle in the event of the issuer’s default. MSCI estimates bond recovery rates for issuer-seniority pairs using the MSCI Credit Curves model.
2Yerak, B. “Hertz Sold $29 Million in Stock Before SEC Stepped In.” Wall Street Journal, Aug. 10, 2020.
MSCI Credit Curves (client access only)