General Motors bankruptcy filing today, plus a massive U.S. Treasury debt issuance this year, will drive up the cost of capital at least in the short term, threatening the incipient economy recovery, managers say.
Its like a stone that gets thrown into a lake: the bigger the stone, the bigger the ripple, said Jonathan Rosenthal, co-portfolio manager at Saybrook Capital LLC, a Santa Monica, Calif. hedge fund, fixed-income and private equity manager.
It doesnt get any bigger than GM.
The question is how big of a risk premium investors will demand from the government and corporations.
Some investors, such as Rosenthal, believe that unsecured bondholders were shabbily treated in negotiations with the government and GM, and that will escalate risk premiums.
Under a restructuring proposal GM unveiled May 28 in a Securities and Exchange Commission filing, the Department of the Treasury would initially own 72.5 percent of a new GM company. The UAWs fund for retiree health care, known as a Voluntary Employee Beneficiary Association, would own 17.5 percent and unsecured bondholders, 10 percent.
In addition, the bondholders would receive warrants to acquire 15 percent of the new GM, exercisable over the next 10 years as new shares are issued. Ultimately, the bondholders could wind up owning more than 15 percent, should they exercise the warrants, depending on the dilution any new shares has on the bondholders' 10 percent initial equity and the original equity of the Treasury Department and the GM VEBA.
The new GM would have $17 billion in debt, including $8 billion owed to the Treasury and $2.5 billion to the VEBA.
This proposed restructuring goes against the laws of financial physics, said Rosenthal. What the government tried to do in Chrysler [LLC] and what it is doing with GM is allowing the union claim to step in front of the bondholders.
When you move pieces in unpredictable ways, worldwide investors feel that risks are higher and the United States becomes a less attractive repository of capital. And they will require higher return, Rosenthal said.
The higher cost of capital will affect every business that relies on debt. Middle-market companies whose loans are variable and based on the London interbank offered rate will see their debt costs soar, leaving them less operating capital and forcing some without sufficient cash reserves to go out of business, he said.
Milton Ezrati, senior economist and strategist for Lord, Abbett & Co. in Jersey City, N.J., agrees there will be a hike in the cost of capital, but hes hoping the impact will be small and short term.
Its easy to exaggerate the effect [on the cost of capital] because other investors will say it [GM] is a special emergency situation and does not mean we have rescinded the rule of law in the United States, Ezrati said. People may demand a little premium for a while, he said, perhaps 12 to 18 months.
If the government orchestration of GMs bankruptcy remains an isolated incident, investors will stop requiring a premium to invest in U.S. Treasuries, corporate bonds and equities, he said.
Andrew W. Bischel, president of SKBA Capital Management LLC in San Francisco, said about the anticipated GM filing: I dont think it will have a big impact because thebankruptcy is so widely anticipated.
GMs Chapter 11 filing will come just as investors have begun renewing their appetite for corporate debt, including high-yield bonds.
Robert Tipp, chief of investment strategies, Prudential Financial Inc.s fixed-income management in Newark, N.J., expressed concern that an expected $2 trillion in debt the Treasury expects to issue this year will push rates up further.
To let the rise in Treasury yields go unchecked will revive investors concern about the ability of the economy to recover because interest rates are going up, he said. That will also spook foreign investors, who see their wealth threatened.
If the economy doesnt recover, it will be hard to get the [federal] deficit under control, he said. The rise in rates threatens the economy, which leads to more issuance of Treasuries, putting more pressure for a rise in rates.
This is crunch time, Tipp said.
Lotsoffs Hershey is not alarmed. The rise in rates is a sign of better credit market conditions, when so much has been related to a flight to quality and a fear of risky assets, he said. Its a sign of health in the economy.
Weve had a significant [rise] of 50 basis points in the last week in the Treasury 30-year bond rate, Hershey said. The increasing yield might be related to better economic fundamentals and better credit markets, greatly assisted by the Feds plan to buy Treasury and mortgage-backed securities to help stabilize the markets.