The clear focus of many analysts during this crisis has been on industry analysis and the overall leverage of the firms. More highly levered firms in the wrong industries are at the financial risk during the "Great Lockdown". The data are readily available on leverage, but that is not the whole story. The real issue is whether firms have more financial flexibility not relative leverage.
Two firms may have equal leverage, but the one with the refinancing of debt further in the futures will be less risky. The debt schedule matters. You don't want to be a CFO for a company that has to refinance bonds and cash flow is impaired. Those firms that have managed to lower cash reserves also have less financial flexibility.
Firms that have placed more emphasis on financial flexibility have often been penalized by activist investors, yet flexibility is a valuable risk management tool when there is a cash flow crisis. Without jumping into the stock buyback controversy, buybacks reduce financial flexibility because firm excess cash is reduced. Even worse is if debt is used to facilitate the buyback.
We should see more value with firms that have high flexibility, but the issue is complex. With the crisis upon us, any policy that attempts to reduce the current liquidity problems should have a greater impact on firms that have less flexibility.
The Fed is trying to support credit markets through liquidity and buying programs which should reduce constraints on less financially flexible firms. The Fed buying programs are not about bailing out corporate bondholders but allowing new debt to be issued in a more friendly debt environment. If bondholders are suffering major losses on their existing positions, new debt will not be able to come to market at reasonable spreads. Financial gridlock will disrupt those firms with less flexibility. The lender of last resort should provide capital to those firms that needs funds and have good collateral. This idea now extends to firms that have flexibility issues from cash flow lockdown problems but have good businesses.
Two firms may have equal leverage, but the one with the refinancing of debt further in the futures will be less risky. The debt schedule matters. You don't want to be a CFO for a company that has to refinance bonds and cash flow is impaired. Those firms that have managed to lower cash reserves also have less financial flexibility.
Firms that have placed more emphasis on financial flexibility have often been penalized by activist investors, yet flexibility is a valuable risk management tool when there is a cash flow crisis. Without jumping into the stock buyback controversy, buybacks reduce financial flexibility because firm excess cash is reduced. Even worse is if debt is used to facilitate the buyback.
We should see more value with firms that have high flexibility, but the issue is complex. With the crisis upon us, any policy that attempts to reduce the current liquidity problems should have a greater impact on firms that have less flexibility.
The Fed is trying to support credit markets through liquidity and buying programs which should reduce constraints on less financially flexible firms. The Fed buying programs are not about bailing out corporate bondholders but allowing new debt to be issued in a more friendly debt environment. If bondholders are suffering major losses on their existing positions, new debt will not be able to come to market at reasonable spreads. Financial gridlock will disrupt those firms with less flexibility. The lender of last resort should provide capital to those firms that needs funds and have good collateral. This idea now extends to firms that have flexibility issues from cash flow lockdown problems but have good businesses.
A cross-sectional event study can highlight the problem of low flexibility and the benefit from a stimulus program. The results are suggestive of the relative value associated with flexibility. See the new paper "How valuable is financial flexibility when revenue stops? Evidence from the COVID-19 crisis". There is value from increased financial flexibility, but companies and investors did not demand that from firms over the last few years. That near-sightedness is now on display in current equity behavior. It is well-worth the read to frame the flexibility issue and provide investors with the right credit focus beyond just leverage.
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