The stock market has been getting bubbly. The extremes in fear of late-March have been replaced with extremes in greed. This is evident from the performance of stocks that have filed for bankruptcy.
Bankruptcy Bubble?
Hertz
At first glance, this price action is puzzling. After all, these companies are in bankruptcy, precisely because they have problems meeting their financial obligations. It's doubtful that they will be able to pay off their debt, so why is there a frenzy to buy their stock? One explanation is that retail traders are piling into these stocks and chasing performance. Data from Robinhood and Fidelity do show that these stocks have been very popular among retail traders. Some of the gains may be due to short-covering as well.
Optimism Spreading
Another explanation is that the market is anticipating a rapid improvement in economic conditions and further easing of monetary policy. This double-dose would result in a rapid appreciation of assets, improvement in business operations, and potentially, lower payments. In March 2009 when the economy recovered and the Fed was stepping on the gas, many stocks in bankruptcy went on to make massive recoveries like General Growth Properties.
Stocks in bankruptcy are basically like a call option with no expiration on the underlying. An improvement in the company's situation or even anticipation of improvement can lead to big gains in the stock. Potential improvement could be revenues improving due to the overall economy improving, lenders giving more favorable terms than expected, more fiscal policy help for struggling businesses, or the Fed pushing another initiative to lower borrowing costs and boost liquidity.
Still Very Risky
These stocks are in Chapter 11 bankruptcy which means their lenders will let them keep operating, while they negotiate on new terms or debt structure. In most cases, stockholders are wiped out, and the lenders are given equity in the new entity.
For stockholders to make money on their investment, the lenders have to be paid in full and money has to be leftover. This mostly happens when the value of a company's assets rise in value during the bankruptcy proceedings which can last for months.
Currently, the bond market disagrees with the stock market's sunny forecast. Debt for these companies is trading at well below par, meaning that bondholders are not expecting to get paid back in full. Typically, bondholders are much more sophisticated than equity traders. They tend to be institutional investors who understand the company's financial structure and prospects at a deeper level and are in touch with management.
