This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC, as well as a contributing analyst to S&P Global Market Intelligence.
Earlier this month, according to numerous media accounts and market comments, novice investors manically bid up the shares of bankrupt companies. See the article referenced in note 1, below, for an excellent summary of that thesis, replete with such choice phrases as “thousands of tiny buyers,” “froth,” and “Call it crazy.”
In the case of Hertz Global Holdings Inc., an alternative narrative emerges from observing how the car rental company's bonds performed in the same period. If the sidelined sports bettors and thrill-seeking video gamers behaved irrationally by bidding up Hertz stock through their $1,000 Robinhood accounts, then arguably so did the professionals who bought Hertz debt.
Equity not invariably wiped out in bankruptcy
To open one’s mind to an alternate Hertz narrative, one must first of all discard the misconception that equityholders' claims invariably become worthless in bankruptcy. That is the conclusion one might draw from not reading quite closely enough comments about Hertz’s stock spike, such as the following. (Italics are added in all cases.)
“Typically, bankruptcy is the end of the line for equity investors…” (note 2)
“Shareholders rarely recover anything from companies that have filed for Chapter 11 because under U.S. Bankruptcy Code, all of a company’s debts must be repaid in full before stockholders recover anything.” (note 3)
“In the past, the court process usually wiped out equity shareholders.” (note 4)
“Stockholders mostly get nothing in bankruptcy.” (note 5)
An overly literal understanding of the Merton Model may also lead one to think that total wipeout is always the fate of equityholders in bankruptcy. Nobel economics laureate Robert Merton very usefully modeled bankruptcy as a decline in the economic value of the assets to the level of the liabilities. At that point, according to his model, the shareholders put the company’s equity to the creditors, leaving themselves with a goose egg. As with most financial models, valuable though they may be for analytical purposes, marketplace realities do not always conform to the Merton Model’s stylized depiction.
READ MORE: Fridson on how the torrid high yield market hints at a return to "normal."
The commentators quoted above were wise to qualify their statements with “typically,” “rarely,” “usually,” and “mostly,” because equityholders do sometimes recover something greater than zero in bankruptcy. In a recent report devoted largely to disparaging the idea of buying bankruptcy stocks, Motley Fool noted that bankrupt utility Pacific Gas and Electric Co.'s reorganization plan “will allow the stock to retain some of its value” (note 6). That outcome was nothing new under the sun.
For 2017, for instance, New Generation Research provided a list of selected companies for which a reorganization plan was confirmed, the company emerged from Chapter 11, and pre-petition common shareholders enjoyed non-zero recoveries. And in the Bonanza Creek Energy Inc. reorganization proceedings, non-opting-out equityholders received pro rata shares of the new common stock plus three-year warrants that upon exercise entitled them to up to 7.5% of the new common stock, which had a total equity value of $1.45 billion (note 7, see also note 8).
Based on such cases, the common stock of a bankrupt company can have legitimate value under an absolute priority regime. This is true even if it currently appears that creditors' claims will not be fully covered. The stock can have option value, based on the possibility that the bankruptcy court will ultimately value the company's assets in excess of its aggregate liabilities. That outcome may arise from a fundamental development that increases total enterprise value, or TEV, much as a similar event would increase the TEV of a non-bankrupt company.
Discarding the notion that stocks of bankrupt companies are inherently worthless enables readers to view the recent gyrations in Hertz stock through the lens of Chapter 11 reorganization proceedings, rather than as manifestation of the madness of crowds. This shift of perspective is reasonable even in the context of unjustifiable investor enthusiasm for certain other bankrupt companies' stocks. To illustrate the point, we contrast the Hertz case with that of a nearly concurrent Chapter 11 filer, J. C. Penney Co. Inc.
One pattern does not make sense, the other may
The first chart below traces the June 2020 price movements of J.C. Penney's common stock and a bond of the bankrupt retailer with a coupon and maturity close to the ICE BofA US High Yield Index's average figures. Between June 4 and June 8, J.C. Penney shares rose by 203%. Over the same interval, the J.C. Penney bond declined by 12%.
 |
There is no rational justification for a divergence of this sort. If J.C. Penney's expected recovery value increased between June 4 and June 8, the bond's value would have risen, albeit by a smaller percentage. (The value of a junior claim is more leveraged to changes in TEV than a more-senior claim's value.)
It is true that in other circumstances a company's stock and bond may have legitimate reasons for moving in opposite directions. For example, a highly rated issuer's bond may decline due to a rise in Treasury yields associated with an improvement in the economic outlook. The improved economic prospects likely increase the company's expected earnings and, by extension, the value of its stock.
No such exception applies in J.C. Penney's case. During the June 4–8 period the ICE BofA US Treasury Index's effective yield did rise, from 0.64% to 0.67%. Over the same interval, however, the ICE BofA US High Yield Index posted a 1.3% price gain. The J.C. Penney bond's drop indicated that it was not mimicking the general movements of speculative-grade issues, but instead responding to idiosyncratic changes in the issuer's fortunes. Judging by the J.C. Penney bond's decline, those fortunes worsened between June 4 and June 8. The logical inference is that the surge in J.C. Penney's stock price was in fact part of a sudden enthusiasm for stocks of bankrupt or near-bankrupt companies, e.g., Whiting Petroleum Corp. and Chesapeake Energy Corp.
Drawing such a conclusion is not as clearly justified in the case of Hertz stock, taking into account evidence from the bond market. The chart below shows, in contrast to the J.C. Penney stock-bond opposite-direction moves during June 4–8, a rise in both Hertz's equity and its debt security. Over that span, Hertz common stock skyrocketed by 269%. Hertz's most actively traded bond, the 5.5% due 2024, rose by an astounding 82%. The bond's lesser (albeit spectacular) percentage gain represented a rational response because, as noted above, the stock is more sensitive to a TEV rise than the bond.
 |
There was more substantive support for a rise in Hertz's TEV during June 4–8 than a spontaneous, fact-free outbreak of enthusiasm among video gamers and sidelined sports bettors speculating in stocks for the first time. For one thing, American Airlines Group Inc. expanded its July flight schedule, signaling a pickup in travel demand that would benefit the rental car business. Similarly, used-car prices fully recovered to the level observed prior to their mid-April collapse. Used-car prices are critical to profitability in the rental car business. Reflecting these favorable developments, shares of Hertz's non-bankrupt rival Avis Budget Group Inc. outperformed the S&P 500 during June 4–8, +13.3% to +3.8%.
Hertz's stock and bond debt continued to move in tandem from June 9 to June 11. In this period, the joint direction was downward, as the company received a letter on June 10 saying that the New York Stock Exchange regulation staff had decided to begin proceedings to delist the stock. The respective price changes were negative 51% and negative 10%, continuing the previous, appropriate pattern of higher volatility in the stock. Hertz's stock decline was intensified by warnings issued on June 9 by some equity analysts. One analyst specified that the shares might have run ahead of fundamentals due to a short squeeze. Note that an exaggerated move driven by a short-run technical factor does not indicate that valuations have definitively disconnected from rational expectations.
On June 11, Hertz announced plans to capitalize on the recent run-up in its share price by selling up to $1 billion of new stock. This prospect of a large infusion of liquidity was followed on June 12 by a 36% jump in the 5.5% bond's price. The stock's reaction marked the instance within our June 1–19 observation period in which the strongest claim could be made that the equity investors acted less rationally than their bond counterparts. Instead of falling in the face of potential dilution by new stock offering, Hertz's existing shares soared by 37%.
Consistent with patterns observed since June 4, the stock moved up more than the bond, but not by much this time; the bond soared by 36%. The stock's negligibly greater percentage price gain may have indicated that not all of the speculators who were driving its price were convinced that the prospect of dilution was outweighed by the possibility that bolstering Hertz's balance sheet would ultimately create a bigger pie to be divided among creditors and equityholders. Perhaps the stock investors' seeming ambivalence was fed by a Hertz attorney's June 12 statement that he had no idea whether the bankruptcy proceeds would produce a recovery for shareholders.
In any event, after peaking on June 12 the bond price fell day by day through June 19, for a cumulative price change of –36%. The comparable share price figure, –39%, consisted mostly of a –34% move on June 15. On that day, the bond price's change measured –9%. During the June 12–June 19 interval, Hertz called off its plan for an equity sale after the Securities and Exchange Commission voiced concerns. Hertz shifted its cash-raising focus to seeking a loan. Our recovery-in-bankruptcy framework may not minutely explain each day's share price change during the final week of our observation period. For June 12–19 as a whole, however, Hertz's stock and bond repeated their previous pattern of large, same-directional moves.
If Hertz stock buyers were wrong, so were Hertz bond buyers
Financial market commentators frequently claim that bond investors are smarter than their equity counterparts. In fact, a recent Seeking Alpha piece made that assertion specifically in the context of prevailing valuations of Hertz stock and bonds:
[T]he bond market is almost always smarter than the stock market, because it reflects the actions of institutional investors who are generally good at assessing risk (see note 8).
No one to our knowledge has suggested that inexperienced individuals with $1,000 Robinhood accounts are driving the price of Hertz bonds. A round lot of the latter still goes for more than $300,000. Given that Hertz's stocks and bonds have consistently exhibited same-directional movement since June 4, as we would expect under conditions of rational pricing driven by recovery-in-bankruptcy considerations, it would seem that one of the two propositions listed below must be true. Because the stock and bond investors behaved similarly, we can rule out a third possibility, namely, that the sidelined sports bettors acted stupidly but the bond investors lived up to their “smart money” reputation.
- Stock investors got the story largely right, along with bond investors, even during the gigantic June 4–8 share price run-up OR
- Bond investors acted recklessly in this episode, along with the wet-behind-the-ears stock speculators.
Proposition #2 may be closer to the truth. If what we have heard is correct, the largest, most sophisticated distressed debt managers are not currently involved in Hertz bonds. This suggests they see value only well below current prices, leaving the field to players who are less seasoned in bankruptcy investing but sufficiently well-capitalized to buy and sell in millions. One possible reason that the usual suspects are holding back, assuming our information is correct, is that they believe used-car prices will sink again when auto dealerships reopen, throwing additional supply onto the market.
Actually calling Hertz bonds' non-customary buyers reckless would be too judgmental, not to mention rude. It is possible that they will get the last laugh, one way or another. June 2020 purchases in the 30s or 40s could ultimately provide attractive returns. By the same token, today's holders may lose their shirts.
Our primary point, though, is that it is too simplistic to describe the June 4–8 spike in Hertz stock as an extraordinary popular delusion, even though it coincided with other run-ups in bankrupt company stocks that were not well grounded in fundamentals. Perhaps the Hertz price surge got overdone as the result of a short squeeze. Viewed through the lens of recovery in bankruptcy and in conjunction with June's bond price movements, the episode does not look as crazy as the financial establishment maintains. If the inexperienced small investors who piled into Hertz stock overestimated the likely value of the company's assets at the end of Chapter 11, they had plenty of company among institutional-sized professionals on the bond side.
Thank you to NYU Stern Professor Emeritus Edward Altman, Independent Credit Research LLC founder Stan Manoukian, and Tufts University Fletcher School Professor Lawrence Weiss for their assistance.
Research assistance by Lu Jiang and Zhiyuan Mei.
ICE BofA Index System data is used by permission. Copyright © 2020 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann, Livian, Fridson Advisors, LLC’s use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
Notes
1. Sarah Ponczek and Vildana Hajric, “Hundreds of thousands of tiny buyers swarm to insolvency stocks,” Bloomberg News (June 2, 2020). This is an extensively researched and solidly supported piece of reporting, notwithstanding the fact that by taking the investigation in a different direction we arrived at a conclusion outside the mainstream.
2. Bradford Cornell, “Are Hertz Global Buyers Paying Something For Nothing?” Investing.com, June 16, 2020.
3. David Welch and Craig Trudell, “Hertz's possibly worthless stock soars in risky recovery bet,” Bloomberg News (June 5, 2020).
4. Ponczek and Hajric, “Hundreds of thousands.”
5. David Merkel, “Hertz donut,” Seeking Alpha (June 18, 2020).
6. Dan Caplinger, “Stock market today: the 1 bankrupt stock that could be worth something,” Motley Fool (June 17, 2020).
7. Kerry Mastroianni, ed. The 2018 Bankruptcy Yearbook, Almanac & Directory. New Generation Research, Inc. (Boston: 2018)
8. For a detailed study of recoveries by equityholders, see Lawrence A. Weiss and Vedran Capkun, “Bankruptcy resolution: priority of claims with the secured creditor in control,” April 18, 2006.
9. Merkel, “Hertz donut.”