“Early last year I was talking to an equity analyst about Invensys,” recalls fund manager Colin McLean. “He said that according to his discounted cash flow analysis, the shares were worth 130 pence [$2.05]. I asked what discount rate he used. He said 6 or 7 percent. Well, Invensys bonds were yielding 9 percent. My point was that if the bond markets say the cost of capital is 9 percent, that is the number you should use.”
McLean, who runs Edinburgh-based SVM Asset Management, did the calculations himself and concluded that at a 9 percent discount rate, the U.K. engineering company was “next to worthless.” He marked Invensys as a potential short for his E600 million ($654 million) hedge fund, Highlander. Last month Invensys announced that two thirds of the group would be sold to stave off breaching loan covenants and that Lord Marshall, the chairman, would step down. By late April the company’s shares were trading down 90 percent from their 52-week high of 127p.
Bonds can tell investors a good deal about stocks, provided they listen. Well before stocks react, bonds give an early warning of difficulties at a company, in a market sector or sometimes even in a whole market. McLean, for one, regularly factors bond prices and yields into equity research tools, like discounted cash flow analysis.
In 1998, just as the stock market bubble began to inflate toward the bursting point, the interest rate spread between U.S. corporate bonds and U.S. Treasuries began to widen. Wary bond investors were signaling a rising risk of defaults even as giddy stock investors loaded up on overpriced shares. The bond markets were right to be concerned: U.S. corporate bond default rates have shot up from barely 1 percent in 1997 to 7 percent today.
“Equity analysts need to think more like their credit counterparts,” asserts Alasdair (Sandy) Nairn, who until recently was chief investment officer of Scottish Widows Investment Partnership in Edinburgh. “The first question a credit analyst asks is whether the company is solvent enough to pay its obligations. Equity analysts should do the same in today’s environment. There is no point moving on to the second stage of analysis -- what value will accrue to equity -- until you understand what the obligations are to higher-ranking instruments. It is simply wrong to start from the premise of solvency.”
Consider Scotland’s ailing Atlantic Telecom Group. Although its bonds sank to extreme junk levels in early 2001, the company still had £500 million of market capitalization. “That was a ridiculous position, a complete disconnect between the bond and stock markets,” says SVM’s McLean. Atlantic Telecom was placed in administration last October, owing £690 million; stockholders, well down the pecking order in bankruptcy proceedings, will be lucky to get back a penny.
Bonds may be a better indicator of the stock market’s direction today than at any time in recent decades. The reason is that after the severe distortions of the late 1990s bubble, the traditional trading relationship between stocks and bonds has been largely restored.
Finance theory holds that equity and fixed-income markets are ineluctably linked. At the simplest level, both depend on companies’ staying strong so they can pay interest and dividends. A stock’s return is supposed to consist of the bond rate plus an equity risk premium to compensate investors for the stock’s greater volatility and bondholders’ privileged claims on assets in bankruptcy.
Thus increasing risk in the corporate bond market -- as evidenced by widening spreads of corporates versus governments (and declining credit quality) -- should send an unmistakable signal to equity investors to be on their guard. The hitch is that equity and bond markets can on occasion decouple: Bonds’ warning signs don’t get processed by stocks.
This happened glaringly in recent times. From roughly 1980 through 1997, U.S. Baa-rated corporate bonds generally traded at a relatively tight 10-basis-point spread over ten-year government bonds. But starting in 1998 this spread doubled, gapping out to more than 20 basis points. Bond investors discerned dangers ahead, but stock investors, fixated on skyrocketing technology stocks, ignored this alarm.
The parting of the ways of stock and bond markets was a sure sign that there was an equity bubble, contends Chris Tracy, global strategist at J.P. Morgan Fleming Asset Management in London. “When a fundamental relationship breaks down, the obvious conclusion is that one of the assets is being priced incorrectly,” he says. “It was equities.”
Bonds aren’t only the bearer of bad tidings, however. “A signal of when the bear market is over will be tightening bond spreads,” says Tracy. “It has happened, but not enough for me to be confident that recent gains in equities can be justified.”
Equity bulls should indeed beware of jumping to conclusions -- the corporate bond market has fundamentally changed. In 1979, 58 U.S. companies had triple-A credit ratings; by 1990 that number had fallen to 27; today just eight companies qualify for such ultra-blue-chip credit status. Fully 40 percent of the corporate bonds in the Lehman Brothers aggregate bond index are now rated below triple-B. “Corporate bond spreads are too high,” warns Tracy, “but it doesn’t stack up to suggest they are heading back to where they were.”
Tracy and other strategists have long held that investors ought to be mindful of overall bond valuations when sizing up the stock market. But a growing number of fund managers now assert that what holds true at the macro level also applies at the micro level of individual companies. Tracy points out, for example, that bubble-era investors might not have been so entranced with high-flying tech stocks like mobile phone operator Vodafone Group if they had bothered to notice that these companies’ bonds were being shunned. (Vodafone stock fell 45 percent in 2000.)
When shopping for stocks for his portfolio, hedge fund manager McLean takes careful note of the credit markets. This applies to both shorts and longs. Like Nairn, he believes that equity investors should think more like their credit peers, especially during straitened economic times like these. Specifically, McLean monitors the widening of spreads on bonds and credit default swaps (a derivative designed to hedge default risk). He also follows the actions of credit rating agencies -- the “negative watch” announcements as well as the outright downgrades. And he watches new-issue activity: If a company cannot sell its bonds, that is a clear-cut negative signal.
After losing £493 million for the year ended March 2002, British Energy tried desperately to raise $400 million in the U.S. bond market three months later -- and failed. That debacle should have alerted investors to a possible meltdown in the nuclear utility’s shares. Most, however, paid no heed to the flashing lights.
British Energy shares edged down from about 180p to 145p between that May and July, but there wasn’t a sharp sell-off until August, when the shares tumbled to 60p. Remarkably, a late-August rally pushed them back up to 80p. Bargain hunters ignored the company’s lack of working capital.
On September 4 British Energy went cap in hand to the U.K. government, requesting a bailout. Trading in its shares was suspended for four days. On September 6 the rating agencies downgraded its bonds to junk. In March British Energy shares were trading at 4p. McLean reports that he did very well shorting the shares.
McLean expends great effort analyzing highly indebted companies. He looks closely at bond and loan covenants, because they can greatly constrict a company’s financing freedom. If its bonds are downgraded to junk status, for example, bankers may be able to demand that bondholders be subordinated to banks in receivership. This extreme step may have the effect of closing the bond markets to that company for many years. Companies that have tough covenants will often do anything to avoid breaching them, with the result that equity investors get called upon to shore up balance sheets.
In 2001 European telecommunications companies that had overexpanded and overpaid for 3G licenses -- including BT Group, Deutsche Telekom and Royal KPN -- carried out a spate of rescue rights issues. Forced to shrink their bloated balance sheets but finding bond markets closed to them, they had little choice but to hit up equity investors.
Nairn describes the perils for shareholders in such solicitations: “When a company becomes heavily indebted, then an equity investor has to go in with his eyes open and realize it is being run for the benefit of bondholders, not shareholders. If there is a chance of a rights issue, unless you really believe in the company in the long term, you shouldn’t be a buyer, because, as has been shown, the company has very little control over the price.”
Just as equity investors can be slow to react to negative news from the bond market, they can also fail to pick up positive signals. Dutch telecom KPN, whose bonds were trading in early 2001 at a horrific 1,000 basis points over swaps, obtained a E2.5 billion standby-credit facility in September of that year and three months later followed up with a discounted E5 billion rights issue.
Bondholders were quick to grasp the benefits of this major balance-sheet deleveraging. KPN’s spreads over swaps compressed. Equity investors, however, didn’t latch onto the KPN story until the start of this year, when they drove up the shares. “It may be that the credit analysts were more rigorous,” says Nairn.
