We hope this won’t cost us our friendship with you, but…
For anyone who lost money trading “meme stocks,” we really don’t have any sympathy.
That may sound harsh. But to be frank, there’s no one else to blame.
They can’t blame the mainstream media, such as CNBC (our go-to mainstream stand-in). They also warned folks to stay clear of them.
The “meme stock” craze was one of the dumbest investor trends of the last few decades.
And yet, as dumb as it was to trade “meme stocks,” dumber still were those lending money to the companies behind them.
So, seeing as Wall Street funds are mostly the big lenders, we have even less sympathy for them.
Because, if the latest reports are anything to go by, the full reality of that may come to pass in 2024.
We’ll explain more on this, and why you should care, in today’s Daily Cut.
But before we continue with our story, today’s market action…
Market Data
The S&P 500 closed up 0.2% to end the day at 4,365.98… the Nasdaq gained 0.3%, to close at 13,518.78.
For individual stocks, Microsoft closed up 1.1% to $356.53… Apple ended higher by 1.5% at $179.23… and Tesla ended the day at $219.27, a 0.3% fall.
In commodities, West Texas Intermediate crude oil trades at $80.87… gold is $1,985.70 per troy ounce… and bitcoin is $35,008.72.
And now, back to our story…
The Dumbest Investor Trend in Recent History
Stand by for an education.
Today, we’ll introduce you to the world of convertible bonds.
If that sounds like a subject about which you’d rather not receive an education, we get it.
At the same time, it’s a mistake to click away or ignore this message.
While we don’t believe the markets are at risk of an imminent collapse, there are major financial matters that investors should follow closely.
Each of them alone is unlikely to cause a crash. But a combination of them – or a “domino effect” of them – could cause problems.
That includes the convertible bond market. It’s an asset class and market that few regular investors would know anything about.
In fact, not being experts ourselves, we asked our Director of Research here at Legacy, Jack Kasprzak, for his input on some of the key facts about convertible bonds.
Jack has more than 20 years of experience in Wall Street research. He previously held Series 7, 63, 24, 55, and 87 qualifications.
That may not mean much to the average Joe. Just trust that it means Jack knows his stuff.
So how could this relatively unknown asset class cause problems? Two ways.
First, for the investors who invested in convertible bonds.
And secondly, for the companies that issued the convertible bonds.
We’ll address these in order. But first, we’ll show why we’re covering this subject today. Then we’ll take you through a crash course on convertible bonds.
The issue comes to light in a recent article from Bloomberg:
Companies from Peloton Interactive Inc. to Just Eat Takeaway.com NV took advantage of investors’ hunger for stocks that boomed during lockdowns by issuing convertible bonds – which can be turned into equity – with no coupon at all. The mania was such that $58 billion of the securities were issued in 2021, an increase of almost 1,100% from two years earlier.
The cheap debt now risks becoming a burden for growth stocks, many of which have fizzled since people began returning to offices and interest rates began to rise. Barring a spectacular rebound, the Covid boom stocks and other companies with zero coupon credit are facing a $69 billion mountain of repayments in the coming three years.
Here’s how convertible bonds work…
The investor who buys the bond is lending money to the company. In return, the investor normally receives twice-yearly interest payments (called a coupon) as a reward for lending money.
At the end of the bond’s term – often one, three, five, or seven years, sometimes longer – the company repays the lender the full amount of the money loaned.
It’s all quite simple.
Unlike a regular bond, a convertible bond lets the investor (lender) convert the value of the bond into that same company’s stock.
That makes this type of bond popular for high-growth stocks. Because if things go well, the investor gets the best of both worlds.
They get the extra security of owning a bond, rather than a stock (if a company fails, a bondholder has a higher-ranked claim on the company’s assets than a stockholder).
And they also benefit from stock price gains if the stock moves higher.
As the Bloomberg story notes, it’s similar to buying a normal bond in a company and a long-term option on the company’s stock at the same time.
So far, so good. But here’s the problem for the investor.
If things don’t go well, you’re at risk of taking a big hit on the bond part of the investment. And as for that “call option” on the stock price?
You can forget about that.
Take Peloton Interactive, Inc. (PTON) for example. When it issued the convertible bonds in February 2021, the stock price was around $150.
It was (or seemed to be) the perfect “pandemic play.” Investors were bullish on it. So when the company set the conversion price from bond to stock at $239, investors lapped it up.
It meant that even if the stock price was $300, $500, or $1,000, convertible bond investors could convert their investment to stock at $239 per share.
Those investors could have converted to stock and sold straightaway, pocketing the difference between the conversion price and the market price.
The problem, of course, is the Peloton stock price is nowhere near $239. In today’s trading, it closed barely above $5.
That means there is zero reason for the investor to convert their bond investment to stock.
And that’s where this becomes a problem for the company…
New Debt to Pay Off the Old
Because now the investor (if they have any sense) only has one option: get their money back when the bond matures.
By doing so, they receive back the full face value of the bond. Depending on the issue, the face value of each bond is usually $1,000 (often with a minimum overall investment amount).
Investors who get their money back can count themselves lucky. They didn’t win big by getting to convert the bond, but they still got their principal investment back.
As an aside, many convertible bonds today are “zero-coupon” bonds. That means they don’t make any regular interest payments.
Instead, for example, the company may have sold the bonds at $910 for a one-year duration. When the investor gets the face value amount of $1,000 at maturity, it means they’ve effectively made a 10% return.
Unfortunately for investors, there’s now a chance they won’t even get their $1,000 back.
As Bloomberg informs us, “Peloton’s bond [is] at 73.7 cents on the dollar [and] Beyond Meat’s debt [is] a lowly 21 cents on the dollar…”
Effectively trading at 26.3% and 79% discounts, respectively, to their face value. That won’t fill any investors with confidence.
Nor should it.
The problem for Peloton and others that issue convertible bonds is they need to refinance that debt. That means issuing new debt to pay off the old debt.
Remember, the company didn’t take the bond investors’ money and keep it in a bank account. They spent it by investing in the business.
As you can imagine, the benefit of convertible bonds for high-growth companies is that if investors do convert from a bond to a stock, they get to keep the bond investors’ money and clear the debt from the balance sheet.
So they likely don’t have the money on hand to pay back bondholders.
Instead, refinancing means borrowing money at today’s Fed Funds Rate (the Federal Reserve’s benchmark interest rate – the one you see quoted in the press) of 5.25–5.5%.
That’s compared to nearly 0% when companies issued these bonds.
Also going against these companies is the fact stocks like Peloton and Beyond Meat aren’t high on investors’ buy lists.
Any bond buyer now will want a substantially higher interest rate. It’s also not hard to imagine they’ll want regular coupon payments, rather than a zero-coupon bond.
Now, that’s not to say these stocks are going bust – although we suggest it takes a brave investor to buy stock in either Peloton or Beyond Meat.
So, what does all this mean?
These Events Do Have Consequences
As we mentioned at the top of this letter, we’re not looking for a single problem that will cause a crash.
And we’re not even saying that every problem will contribute to an eventual market crash.
But we do believe these problems are symptomatic of an overall unhealthy and unstable market.
These are the symptoms caused by 14 years of historically low interest rates.
These are the symptoms of central banks insisting the economy needed inflation instead of the perceived boogeyman of deflation.
These are the symptoms of big government spending, budget deficits, and escalating government debt.
These are the symptoms of companies that should never have been viable in the first place. Not then… not now… and maybe never.
These situations are only just emerging now. But this is only really the beginning of this next phase of the cycle.
As 2024 unfolds, you should expect to see more examples like this in the market. Peloton is just one example. There were more than $58 billion worth of these bonds issued during a crazed period in the market.
As these bonds reach maturity, there will be more companies seeking refinancing and competing for limited investor interest. To attract investors, the strongest of these companies will still likely need to offer a high yield. That has the potential to spell trouble for the weaker companies.
It goes to show that these events do have consequences. Perhaps not always immediately. But at some point. The timing is the only unanswered question in our minds.
We’ll make sure to keep you informed. We’re here to help you make sense of it all… and to help you invest accordingly.
One More Thing
Teeka’s Final Collapse feature presentation is coming up fast.
This Wednesday, at 8 p.m. E.T., Teeka will reveal the details of an “unprecedented event” that will impact most Americans.
Teeka says it’s guaranteed to happen this month, and it will “lead to the final collapse of Americans’ purchasing power.”
If you think that’s something you can afford to ignore, Godspeed to you. But if you have even an ounce of curiosity – and you want to make sure you’re prepared for the event Teeka sees coming – you better tune in.
To do so, go here.
Unconnected Dots
Our main task at The Daily Cut is to try to “connect the dots.” That is, we help you figure out what events are about, what makes them important, their consequences, and what it all means for you.
But sometimes, we see the individual “dots,” but can’t yet figure out how they connect to anything. Maybe they never will connect to anything.
Regardless, if those unconnected dots feel as though they could be important, we’ll mention them here. And we’ll let you draw your own conclusions.
Today’s unconnected dots…
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CNN, everyone’s favorite news network (we kid), reports:
Alphabet’s Google has scrapped a development deal to build $15 billion worth of homes, offices, and retail space in California’s Silicon Valley.
Google and Australian developer Lendlease ‘mutually reached’ a decision to end their San Francisco Bay Project for four master-planned districts in the cities of San Jose, Sunnyvale, and Mountain View, Lendlease announced Friday.
“The decision to end these agreements followed a comprehensive review by Google of its real estate investments and a determination by both organizations that the existing agreements are no longer mutually beneficial given current market conditions,” Lendlease said in a statement.
This is a real-world example of the rising interest rate story. It’s easy to get bogged down in theory or hypothetical examples.
This decision by Alphabet and Lendlease proves that companies are making important business decisions based on a new era of higher interest rates.
As we mentioned earlier, this doesn’t necessarily mean crashing markets… or crashing property prices… or crashing anything. But it’s another “dot” worth watching.
If it affects Alphabet, there’s zero doubt it impacts other companies.
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Bloomberg informs us of the impending demise of another company that existed only because of low interest rates. The company in question is WeWork Inc. (WE):
When WeWork Inc. announced a multibillion-dollar rescue package earlier this year, the company’s management hailed it as a fresh start for the long-struggling global network of shared office spaces.
The deal would cancel burdensome interest payments, provide funding for years to come and support a revamped plan for profitability, they said at the time.
Just eight months later, the coworking company is on the verge of filing for bankruptcy. Shareholders, including Masayoshi Son’s SoftBank Group Corp., are likely to see their equity stakes wiped out, while most creditors may recover just pennies on the dollar.
We’ll take a closer look at WeWork and see if there’s anything worth passing on… even if it’s only to write its obituary.
More Markets
Today’s top-gaining ETFs…
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VanEck ChiNext ETF +2.8%
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KraneShares MSCI All China Health Care Index ETF +2.1%
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KraneShares Electric Vehicles and Future Mobility Index ETF +2.1%
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iShares MSCI Turkey ETF +1.9%
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Invesco China Technology ETF +1.9%
Today’s biggest losing ETFs…
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Invesco Energy Exploration & Production ETF -2.3%
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Invesco Dorsey Wright Healthcare Momentum ETF -2.1%
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Pacer Benchmark Industrial Real Estate SCTR ETF -2.1%
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Nuveen Short-Term REIT ETF -1.8%
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Invesco Active U.S. Real Estate Fund -1.8%
Mailbag
If you have any questions or comments for our experts here at Legacy Research, we’d love to hear from you.
Write to us at feedback@legacyresearch.com and just type “Daily Cut mailbag” in the subject line.
Cheers,
Kris Sayce
Editor, The Daily Cut