Bad correlation is back

Good morning. It took markets a day to decide that the Fed is serious about this whole higher-for-longer thing. Stocks and bonds sagged yesterday. Maybe this is not a Goldilocks market after all? Send us your thoughts: [email protected] and [email protected].

Stock-bond correlation

A question for readers. Let’s say that next week, for whatever reason, stocks have a meltdown. They fall 10 per cent, let’s suppose, on some alarming combination of corporate and economics news. Would bond prices rally? 

The question is important. A lot of investors own bonds because, in a stock-heavy portfolio, they can provide diversification. That is to say, in recent decades stock and bond prices have been mostly negatively correlated. That is in part a byproduct of low inflation. When prices are stable, if growth weakens significantly and stocks fall, the Fed cuts rates and Treasuries rally. In an inflationary environment, where the Fed is tightening policy, you can’t count on this. The Fed can’t be cutting rates willy-nilly every time growth stalls. Indeed, it may have to increase rates in the face of weak growth. It becomes entirely possible for stocks and bonds to fall together.

From May through July, the two assets headed in opposite directions (stocks up, bonds down), reflecting economic growth that re-accelerated despite high and rising rates — an unusual combination. Since August, bonds have kept falling, but now stocks are doing the same (the pink line is Treasury yields inverted, so it falls when bond prices do):

If stocks were to hit the rocks due to bad economic or corporate news, perhaps bond investors would conclude that the Fed would cut rates sooner, and bonds could rally. But the history of the stock-bond relationship since the pandemic suggests that as long as further rate increases are even a possibility, the safe bet is that stocks and bonds will march in unison:

We are keen to hear from readers on this. 

Private equity’s new leverage layer

This story, which our colleagues Antoine Gara and Eric Platt wrote last week, does not inspire confidence:

Buyout firms have turned to so-called net asset value (NAV) loans, which use a fund’s investment assets as collateral. They are deploying the proceeds to help pay down the debts of individual companies held by the fund . . . 

The borrowing was spurred by a slowdown in private equity fundraising . . . that has left many private equity firms owning companies for longer than they had expected. They have remained loath to sell at cut-rate valuations, instead hoping the NAV loans will provide enough time to exit their investments more profitably . . . 

Private equity executives who spoke to the Financial Times noted that the borrowings effectively used good investments as collateral to prop up one or two struggling businesses in a fund . . . 

Executives in the NAV lending industry said that most new loans were still being used to fund distributions to the investors in funds. One lender estimated that 30 per cent of new inquiries for NAV loans were for “defensive” deals.

In short: PE is increasingly borrowing at the fund level to help out individual portfolio companies, rather than putting the debt on the individual company’s book. NAV lending is not new, but now PE firms are using it to buy time.

One reaction you could have here is: yikes, looks desperate. PE firms are using leverage on top of leverage to prop up companies battered by higher rates, in the hope of better exit valuations at some point down the road. What if rates do indeed remain higher for longer and those better valuations never come?

NAV lending looks especially scary given PE’s return profile. Schematically, an average PE fund makes something like 10 investments, and if two or three go bust that’s OK, so long as it makes big returns on the other seven or eight. The fund generates returns by not throwing good money after bad. NAV lending does the opposite. It uses good investments as collateral to backstop bad investments, on the thinking that if enough time is bought, markets will get friendlier and things will be OK. If that’s wrong, it could jeopardise returns.

The vocal PE critic Dan Rasmussen, who runs Verdad Capital, told us: “NAV loans are a last resort for funds in dire straits or with deeply troubled portfolio companies. This is the first puncture in the private equity bubble.”

Does this underestimate PE’s strengths? As Unhedged has argued previously, private equity is leveraged equity; the aggressive, creative use of borrowed money is PE’s core competence. The intellectual risk here is doing the equivalent of looking at a perfectly good bank and saying, “By Jove, they’re leveraged 10 to one! Run away!” 

Compared with individual portfolio companies, PE funds are bigger and more diverse, and so can borrow at lower rates (the FT story mentions one deal where the savings were on the order of 450-650 basis points). If portfolio companies can’t easily borrow at current rates, taking on debt at the fund level may also be better than the alternative, which would be raising fresh equity in the company. The fund retains all the upside of its equity investment, while getting money that can be put to work right away. 

Still, today’s elevated debt costs are terra incognita for most PE funds. In this higher cost of capital environment, NAV lending is “a sign of froth”, says Brian Payne, a former pension portfolio manager who is BCA Research’s newly minted private markets strategist. He figures there will be a few scattered fund blow-ups, but the likelier problem may be disappointing PE returns. Payne says:

We wouldn’t expect 20-25 per cent [internal rates of return] like we’ve seen in years past . . . maybe it’s more like 5-10 per cent returns in [leveraged] buyouts. Is that enough of a risk premium relative to public markets to lock your capital up for years on end? A lot of investors might just say no.

This feels right, and has the advantage of matching the broad story in public markets. High public equity valuations have so far held up, but the expected returns don’t look particularly compelling, especially relative to fixed income. Perhaps private equity is not so different. (Ethan Wu)

Errata

Yesterday we wrote about the Fed’s summary of economic projections, best known for its “dot plot”. In the SEP, officials write down what they think growth, inflation, unemployment and rates will do over the next few years. We made two mistakes, neither of which changes our argument but which are important to note nonetheless.

First, we said the Fed’s Open Market Committee had 19 members. In fact, it has 12, but once you include seven regional bank governors, 19 people submit SEP forecasts. Ergo, 19 dots on the dot plot.

Second, we said, “The members’ degree of confidence in their estimates is not recorded, but it is surely very low.” William English, professor of management at Yale who helped design the SEP, wrote in to point out that members do in fact record their degrees of confidence, in figures 4A through 4D. For example, in the latest SEP, a solid majority said their projections for GDP growth were more uncertain than usual. We regret the errors, and will do better. 

One good read

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