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Why Stocks And Bonds Sometimes Value Risk Differently
Source: Dow Jones Capital Markets Report
Date: February 26, 2004
Author: Liz Rappaport
NEW YORK (Dow Jones)--Is the glass half empty or is it half full? It all depends whether you hold stocks or bonds.
Unsecured bonds of some highly speculative companies, such as independent power producer Calpine Corp. (CPN), are trading at distressed levels - indicating that bondholders are concerned about the potential to be repaid. But the shares of these companies are trading between $4.00 and $5.00, pointing to a greater degree of confidence in the company's prospects.
Behind this divergence lies a fundamental difference in the psychology of bond and stock investors, particularly when it comes to volatile companies and sectors with uncertain futures. And these different ways of valuing risk can lead to trading opportunities that further exacerbate the gap.
"Investors do sometimes overvalue the stocks of distressed companies," said Marty Fridson, publisher of Leverage World. But Fridson also said that it would be overzealous to suggest that if a company's bonds are discounted, its stock, further subordinated on the capital structure, should automatically be valued at zero. Stocks are inherently more volatile than bonds. If a bond is up, its stock is frequently up more, and vice versa.
Typically, the share price of distressed companies - defined as companies whose bonds trade at a 1000 basis point yield margin over Treasurys or more- hovers below $4.00 per share, portfolio managers said.
Besides Calpine, the disconnect between the stock and the bond price can also been seen for energy producer Dynegy (DYN) and cable company Charter Communications Inc. (CHTR), among others.
Market psychology is one reason. "Bond investors are inherently pessimistic and stock investors are inherently optimistic," said Roger King, high-yield specialist at independent research firm CreditSights.
This can lead to very different dynamics in these markets even though fundamental factors such as an economic recovery would appear to support both.
For example, the riskiest companies in the high-yield market rode the tide of the initial economic upturn, as investors collected 30% returns. Now, with the economy in full blaze, those rising-tide returns are over, and inflows into the market have slowed. High-yield investors are becoming more selective about the risk they take on to guard against the possibility that some of the riskiest companies in the high-yield market could eventually fail.
Stock investors, too, saw huge returns in 2003 across the board, with the riskiest sectors, such as telecom and technology, posting the best gains. The Nasdaq Composite Index rose 50% in 2003, far outpacing high-yield gains. This week saw a correction, but the index remains above 2000, reflecting continued optimism that growth will continue to boost these companies.
Another dynamic at play that can cause a price gap is that bonds are callable at different stages of their lives, so the company may buy them back at par or a few percentage points over par. This guarantees a bondholder a certain value for their investment, but also puts a natural ceiling on how far a bond can rise in price. Stock investors have no guarantees of any returns, and their entire strategy is based on betting the stock will increase in value, but there is also no upper limit on how far a share price can rise.
Trading Opportunities
On average, only 20% of the prices in the bond market diverge, in terms of their valuation of risk, from the same issuer's stock price, according to Moody's KMV, a credit risk technology firm and a wholly-owned subsidiary of Moody's Corp. (MCO).
Half of that 20% demonstrate the equity market leads the bond market in terms of the direction of price fluctuations, said Jeffrey Bohn, managing director of research and project management at Moody's KMV. There are more cases where the equity market successfully signals the bond price will fall than cases where the equity market signals the bond price will rise, he said.
Other than the psychological rift, there are a number of reasons why this fairly rare stock-bond disconnect- which usually corrects itself after three to four weeks, according to Moody's KMV - can happen.
One reason for the gap could be that dealers in different markets are processing information at different speeds, ultimately resulting in the appearance of disparate assessments of how risky the company is, said Bohn.
For example, stock traders latched onto Xerox's financial troubles several weeks sooner than bond traders did, said Bohn. The stock tumbled, signaling that the bonds were going to crash, which indeed they eventually did.
Such disconnects present trading opportunities. "Several people were very successful on that trade," said Bohn.
Some investors use strategies to make money off of these differences, which can accentuate the disparities. Called "capital structure arbitrage," investors take bets that one asset class will see its price fall - known as short-selling - while at the same time betting that the other asset class will see its price go up - known as taking a long position. These investors often find use for the strategy in sectors where the future is so uncertain that the disconnect can take hold as investors bet solely on their belief in the sector's future, said CreditSight's King.
Both the power industry and the cable industries are rife with uncertainty. The cable industry is seen as ripe for consolidation, while the oversupplied independent power plant and merchant energy industry depends heavily on a build-up in demand that will be sufficient to eat through the excess capacity, among many other factors.
The disparities could also be due to the increased volatility in a short period of time in all markets recently, said Leverage World's Fridson. "It could be that one market has rebounded more quickly than others (for certain issuers)," he said.
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