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Macro Strategy
GE, the 100 Billion Dollar Credit in the Room
I have three strong opinions that I wrote about in detail on Monday in DEBT is a 4-Letter Word
and had the pleasure this week of discussing my views on Bloomberg TV and CNBC.
1. Credit is NOT leading the way – equities have been dragging credit down
2. Some companies will need to address balance sheet returns in order to enhance
shareholder value – and they will take those necessary steps
3. Credit risk does not pose a systemic risk
While I rarely focus on individual companies, it is impossible not to spend some time on GE. The
size of the debt, the amount of investor interest in the company across the capital structure and
the sheer volume of bond trading make it a focal point for credit markets. It also seems as though
there is some misinformation being spread as non-credit investors chime in.
I am not a credit analyst, so my thoughts are from a macro viewpoint and decades of experience.
While the company faces real questions on earnings, the state of the pension plan, etc., there
does seem to an aura of hysteria surrounding their credit risk, that I hope to dispel and bring
back into the realm of reality. Poor liquidity in the bond markets is also a culprit in exaggerating
moves in both directions, which is something that needs to be taken into consideration.
GE – The 100 Billion Dollar Credit in the Room
Let’s start on the journey of examining what is going on with GE’s bonds by starting with the
credit derivative market.
General Electric Company 5 Year CDS
Unless you were stranded on a desert island last week, with no internet, it is almost impossible
that you didn’t see this chart or something similar.
November 21, 2018 1
GE, the 100 Billion Dollar Credit in the Room
General Electric Co CDS has blown out from 57 bps in late September to 260 bps on Friday
(according to Bloomberg). It did finally tighten a little bit yesterday and is continuing to tighten
today. You can also see, that the credit spread widening is a more recent trend.
GE CDS Did NOT Lead the Way
If credit was the cause of the problems for GE, you would have expected a much difference
chart. GE lost more than 25% in terms of share price in late 2017 while CDS spreads tightened.
Again, from late May until the middle of September, GE lost another 25% in market value while
credit spreads tightened. Clearly stock price has led the way, not credit spreads! While the
stock leading the way down isn’t necessarily a good thing, I think it highlights that the current
concern surrounding the credit can be fixed. I’m more concerned when credit leads the way,
and I just don’t see that in these chart patterns. This looks like equity weakness has started
leaking into credit, which became more concerned as rating agency downgrades hit and then
bonds were sold into a liquidity vacuum. That, I believe is a pattern that is often reversed rapidly.
Before moving on, I want to highlight a couple of issues with the CDS market
• Charts of credit spreads tend to look a LOT worse than they actually are. While the move
from 63 bps on September 20th to 260 bps on Friday looks awful, it is ‘only’ an 8% move
in terms of the price of CDS which is all that matters (all CDS spreads are converted to a
price for purposes of exchanging fees and a 200 bp move is approximately 8%). While 8%
is definitely bad, the stock moved 35% in the same timeframe. I’m not saying the move
in credit is good, just that it is roughly in line with equities and that the spread charts
are more alarmist than the reality.
• Timing is crucial in the CDS market. While we look at 5-year CDS charts, the reality is that
it is a series of contracts that changes every 6 months. That ‘roll’ down the curve has a
large impact on CDS values as does the cost of carry which tends to cause CDS to be
extremely volatile at the best of times, let alone when investors, who find bond market
liquidity lacking, or don’t want to sell bonds for a variety of reasons, all rush to the CDS
market at the same time. By my calculations, had you bought CDS on GE at 110 on March
November 21, 2018 2
GE, the 100 Billion Dollar Credit in the Room
26th, you made just over 3.5% with it now trading at 260 bps as the curve and carry
impacted your profit. Just a small reminder of how crucial timing is when shorting
credits.
My point is that the equity led the way and while the CDS story is not positive, it may also be
making the damage look worse than it is.
GE’s Cost of Debt Will Take Years to be Affected
Another thing I have heard mentioned is ‘how will GE deal with increased costs’? I had to do a
bit of a double take when I heard that one. It will take a long, long, long time for GE’s costs to be
materially affected by widening credit spreads (depending on how much floating rate debt they
have outstanding, including any swaps) they are likely to feel a more immediate effect from rate
hikes and LIBOR rising faster than other benchmark rates than it would from spread widening
(the rate hikes affect all companies depending on their exposure to floating rate debt).
GE Commercial Paper Outstanding
GE’s commercial paper program, which got downgraded from A-1/P-1 to A-2/P-2 on October 2nd
and October 31st respectively, was down to just over $6 billion at the end of September
(according to Bloomberg). While large relative to many issuers, it is smaller than the $25 billion
or more they carried before restructuring the company. The CP, since it is short dated, bears the
brunt of both rate hikes and spread widening as it will need to be rolled. But even a 2% increase
on the cost of the CP would only add $120 million of costs per annum – if they kept $6 billion
rolling. Not a small number on an absolute basis, but still a relatively small number for an almost
$70 billion market cap company.
Probably worth repeating, that despite all the handwringing, the company still has an equity
market capitalization of almost $70 billion.
Anyways, GE has almost $38 billion of revolving credit available (according to Bloomberg). The
$20 billion 2021 facility seems to cost L+25 bps to drawdown – giving them immense flexibility
and access to relatively cheap money if the loan is available and they drawdown on it. Companies
tend to avoid drawing down on their loans, but it is important to note that these facilities exist
November 21, 2018 3
GE, the 100 Billion Dollar Credit in the Room for all the doomsayers. When we look at just the bonds outstanding (again, according to Bloomberg data), we see: • $105 billion across 451 issues • $0.4 billion coming due in 2018 • $7.7 billion coming due in 2019 • $18.1 billion coming due in 2020 (a rather large amount) Put another way, GE has $79 billion of debt that is over 2 years from maturing and has extended their average maturity over the past several years. GE’s current weighted average coupon is 3.98% and the weighted average years to maturity is 9.04 years. Some of the debt maturing in 2019 includes some high coupon debt. There is a €1 billion bond with a 6% coupon maturing that was issued back in 2008 and another $1.22 billion USD 6% bond maturing in 2019, which was issued in 2009. Not all the debt maturing is such high coupon debt but depending on how they refinance or repay the maturing debt their average coupon may not increase much in 2019. GE should not see a material increase in their total cost of borrowing in 2019, despite spread widening in the secondary markets because of their debt profile. That should help alleviate some concerns that I have read, that made the top of my list in terms of fearmongering misinformation. GE’s Debt Outstanding Has Been Declining With large companies it isn’t always clear what their obligations are based solely on public debt (in GE’s case in particular, pension fund obligations are an issue that has been affecting credit quality and bond prices), but the following chart is interesting. Total Debt Has Been Declining November 21, 2018 4
GE, the 100 Billion Dollar Credit in the Room Since the start of the year, total debt dropped 15% (according to Bloomberg), a not insignificant cut of $20 billion. GE’s Dividend Cuts, Shares Outstanding and Asset Sales GE used to pay 24 cents a share back in the halcyon days of early 2017. That was cut to 12 cents late last year and cut to 1 cent now. With 8.7 billion shares outstanding, they used to pay out around $8.3 billion a year. Now it will be $0.3 billion a year. That frees up close to $8 billion of cash flow – which I’d argue is a pretty significant amount no matter how you slice it. GE Shares Outstanding GE had shares outstanding dropping in the early part of 2017 as they were in the midst of share buybacks (they had so many more shares outstanding if you go back to 2016 it screws up the scale of the chart). But since then, slightly more shares outstanding exist now than they did then. They haven’t done any public offerings so I’m not sure how the shares outstanding is growing, but I also don’t think that changes the point – from buybacks to slowly diluting the equity holders. Might not be great news for the equity but it seems like the sort of responsible behavior creditors generally respond well to, all else being equal (which apparently right now, not all else is equal). GE announced that it reached a deal to sell part of its stake in Baker Hughes, providing around $4 billion. Ironically, at least to me, the equity rallied on that while bonds continued to sell-off. Again, not being a credit analyst, it seems that stopping buybacks, cutting the dividend and selling assets are all steps in the right direction from a creditor’s perspective. November 21, 2018 5
GE, the 100 Billion Dollar Credit in the Room
How Close is GE to Being Junk?
I’m stuck staring at a headline from a large media organization:
GE was once America’s most valuable company. Today it is fighting junk-bond status.
Wow. That seems like an extremely aggressive, if not misleading statement.
To me, BBB+ without even a negative outlook strikes me as safely away from junk for the
foreseeable future, but let’s walk through the recent history of GE’s ratings.
GE started its new life in 2016 as AA- (S&P’s rating as of 9/23/2016). They were put on -ve watch
back in October 2017 and downgraded to A in December 2017. They were put back on negative
watch in June of 2018 and dropped to BBB+ on October 2nd.
They are outlook stable at this time with S&P. Could S&P turn around and put them at junk
tomorrow? Of course. But realistically, the rating agency doesn’t like to do 3 notch downgrades,
and they have just done back to back 2 notch downgrades. This leads me to suspect that there is
a fair degree of breathing room for the company, and I would be absolutely shocked if there
weren’t frequent consultation between the company and the rating agency as they take steps
that seem to be focused on improving the balance sheet.
Moody’s had GE at A1 in April of 2015 and moved them to A2 in November 2017 (it doesn’t look
like they got put on watch first). On October 2nd, the day S&P cut GE to BBB+, Moody’s put them
on negative watch and followed up with a cut to Baa1 on October 31st.
Fitch, the other rating agency which is a determining factor on which index a company goes into
(I think most indices consider a company IG if 2 of the 3 have them as IG, but will triple check
that). Fitch had them AA- in August 2016, down to A+ in November 2017, took them down to A
in June 2018 before putting them on negative watch on October 1 (a day before S&P downgraded
them and Moody’s put them on watch). They downgraded GE to BBB+ on November 2 nd.
So, as of today, all three rating agencies (technically Nationally Recognized Statistical Rating
Organizations) have them at BBB+ (or their equivalent rating) and all are on stable outlook.
They all had the opportunity to leave them on negative outlook or even negative watch and
didn’t. We all can try and read between the lines of what the rating agencies are telling us, but
it seems like it could have been worse. My experience is you often have more breathing room
from the rating agencies if they do 2 notches and take you off outlook, than 1 notch and leave
you on negative watch, but that is subjective and can change as the agencies get new
information. They also tend to be ‘sticky’ in terms of downgrading to junk, because they are well
aware of the consequences that it has. Losing the A-1/P-1 rating was a sign that the agencies
are serious about this as they typically don’t take that step lightly – especially for a large issuer.
The fact that it is the power division that was referenced in rating agency actions is concerning
as oil prices slump again.
Not sure you can take comfort in how the rating agencies left it, but it also wasn’t as bad of a
message as they could have sent.
November 21, 2018 6GE, the 100 Billion Dollar Credit in the Room The GE 5% Perpetuals are NOT Bonds I’m not going to spend much time on this, but I think given the amount of chatter these securities have attracted, I can’t help myself, as I think it could signal just how much ‘tourist’ activity there is in this name. I’ve seen people discussing the GE 5% Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Stock, Series D shares as though they are bonds. While these securities are rated Baa3/BBB- they are not bonds which are rated Baa1/BBB+ as discussed in detail above. While it is scary to watch the Perps drop from 100 in late September to 75 last week, it is important to remember that not only are these not bonds, they are complex in their own right with their callability, dividend rate that changes over time, that doesn’t necessarily have to be paid under certain circumstance and lack of a final maturity date. Bottom line is the perpetuals are a strange instrument with their own supply and demand dynamics that tell us very little about the overall credit of GE and anyone pointing to these bonds as part of the credit story is, at best, in my opinion, barking up the wrong tree. Bond Price Matters a Lot The GE 4.5% bonds due in 2044, on the other hand, are the longest dated bonds issued by GE with an amount outstanding of greater than $500 million (this issue happens to be $2.25 billion), and are important to look at. These bonds have also had a rough ride, trading down from 95 in late September to 77 as of Tuesday’s close. Only a small fraction of this move can be attributed to interest rate moves, so we are seeing weakness across the curve. Prices matter for all assets you buy or sell, but we often talk about bonds in terms of yield or in terms of spread, but in any stressed situation, the price of the bonds matters. The closer you are in current price to any expected recovery value, the less downside risk there is to holding a bond. Two bonds, both at T+300, but one with a high coupon trading at $110, and one with a lower coupon trading at $80 do NOT have the same risk/reward profile. Yes, yield and spread are important factors when buying and selling bonds, but in situations where there is any real credit concern – low prices will attract distressed buyers because the downside is limited. The good news here is that many bonds were issued in low interest rate environments, so they have prices well below par. That will let a floor be established on the bonds sooner than if there were a lot of high coupon, high dollar priced bonds. When I used to trade, I generally liked buying 5-year CDS versus buying long dated bonds with low dollar prices as a ‘volatility’ play. Simplistically, the view is that the situation will resolve itself long before 5 years are over and you have some good convexity in the trade regardless of the outcome. That trade would be another reason you could see pressure on CDS even while longer dated bonds start finding buyers. (I haven’t looked at this name closely enough or worked with an analyst to know whether that makes sense or not at these levels for this name, but I’d certainly be running some numbers with my analyst on that now). November 21, 2018 7
GE, the 100 Billion Dollar Credit in the Room
Bottom Line
GE was an equity story that became a credit story. If this had started as a credit story, I’d be
more concerned that the root causes of weakness are intractable and difficult to solve.
Right now, I think markets are poised for a rebound on the credit front as
• The company is taking the right steps, at least from a creditor perspective
o Cutting the dividend, not once, but twice
o Asset sales, with proceeds presumably used to reduce obligations
o Ending share repurchases and actually seeing shares outstanding increase
o They did extend their maturity on the balance sheet which also gives ample
breathing room
o Even at these current stock prices, creditors have a buffer of almost $70 billion
beneath them in the capital structure
• There is misinformation and alarmist statements and commentary that are more
hyperbole than rational analysis. As market participants sort through the noise to focus
on the facts, we should see a calming effect. There seems to be a cottage industry of
‘credit tourists’ calling for another credit led crisis regardless of the fact that the overall
credit markets look nothing like they did in 2007/2008 and why I see almost no evidence
of credit posing a systemic risk.
• Bond markets are illiquid and that is particularly true for companies with a lot of debt that
needs to be traded suddenly. Price action is extremely likely to overstate the impact of
any news or information – in both directions. While it is difficult to not let price action
determine analysis, we have to be particularly careful here to ignore it as best as we can.
Price action right now may carry far more noise than signal and we have seen time and
again, market makers with smaller balance sheets and smaller P&L tolerance flip on a
dime. The potential for a strong reversal in spreads and prices is there.
GE has a large and complex capital structure and business model that will require a lot in depth
analysis for investors to make their decisions, but from a macro view, focused on positioning
and sentiment, there are a lot of positives to point to.
November 21, 2018 8GE, the 100 Billion Dollar Credit in the Room Disclaimer This document and its contents are confidential to the person(s) to whom it is delivered and should not be copied or distributed, in whole or in part, or its contents disclosed by such person(s) to any other person. Any party receiving and/or reviewing this material, in consideration therefore, agrees not to circumvent the business proposals explicitly or implicitly contained herein in any manner, directly or indirectly. Further, any recipient hereof agrees to maintain all information received in the strictest confidence and shall not disclose to any third parties any information material to the opportunity contained herein and, upon review hereof, agrees that any unauthorized disclosure by any party will result in irreparable damage for which monetary damages would be difficult or impossible to accurately determine. Recipients recognize, and hereby agree, that the proprietary information disclosed herein represents confidential and valuable proprietary information and, therefore, will not, without express prior written consent, disclose such information to any person, company, entity or other third party, unless so doing would contravene governing law or regulations. This document is an outline of matters for discussion only. This document does not constitute and should not be interpreted as advice, including legal, tax or accounting advice. This presentation includes statements that represent opinions, estimates and forecasts, which may not be realized. We believe the information provided herein is reliable, as of the date hereof, but do not warrant accuracy or completeness. In preparing these materials, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. Nothing in this document contains a commitment from Academy to underwrite, subscribe or agent any securities or transaction; to invest in any way in any transaction or to advise related thereto or as described herein. Nothing herein imposes any obligation on Academy. Academy is a member of FINRA, SIPC and MSRB. Academy is a Certified Disabled Veteran Business Enterprise and Minority Business Enterprise, and is a Service Disabled Veteran Owned Small Business as per the US SBA. Investment Banking transactions may be executed through affiliates or other broker dealers, either under industry standard agreements or by the registration of certain principals. November 21, 2018 9
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