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Capital structure investing links stocks and bonds
Source: Reuters
Date: August 7, 2003
Author: Dena Aubin
Think getting the right mix of stocks and bonds in a portfolio is the best way to weather unpredictable markets?
In a new approach, some money managers are turning that thinking on its head. It is not the outlook for the stock or bond market that is important, they believe, but looking at the stocks and bonds of each company to find where the best value lies.
"The whole idea here is to decide which is the instrument that gives the best risk-return exposure to a company," said Michael Maras, head of global credit and equity-linked research for Merrill Lynch & Co. (MER.N). "Under the old regime and thinking process, that kind of issue would never come up, because you had these Chinese walls between products."
Called capital structure investing, the strategy is akin to arbitrage plays long used by hedge funds, which take advantage of mispricings among asset classes by buying a company's debt, for example, and selling its stock short.
That is a departure from traditional mutual funds and brokers, where stock and bond professionals have long operated in different worlds.
"Hedge funds have an edge because they have a free mandate so they can trade wherever they want," said Maras. "Recently, what we realized was there was a rapidly growing number of institutions that were breaking down the walls between debt and equity."
Last December, Merrill Lynch began combining debt, equity and convertible bond research in capital structure reports on industry sectors. UBS also has combined equity and high-yield debt research on the cable television and satellite sector under analyst Aryeh Bourkoff.
On the investor side, Sentinel Funds in March launched the Sentinel Capital Markets Income Fund under manager Prescott Crocker to seek the best income opportunities in bonds, common or preferred stocks or convertible debt.
In part, the new approach takes advantage of common sense notions rooted in bankruptcy law. For troubled companies, bonds can be a better play than stocks, because they have a senior claim on a company's assets, while equity investors recover little or nothing in most bankruptcies.
For companies with growth potential, however, stocks offer unlimited upside, whereas bonds rarely rise much above their original price.
Because of heavy debt and mounting competition, UBS' Bourkoff has had a neutral rating on shares of cable company Charter Communications Inc. (CHTR.O). Yet an analysis of its assets and capital structure convinced him in April that the bonds were a buy. They have risen to 75 cents on the dollar from 50 cents when he began recommending them.
Mutual funds that can comparison-shop throughout a company's capital structure are relatively rare, partly because of long-standing divisions in the industry, said Eric Jacobson, a Morningstar analyst.
"There's no question that there are some really big thinkers who do a lot of things really well, but by and large there's been a realization that there aren't many of those folks," said Jacobson. "In many cases, you're better off piecing together really good managers who do different things really well."
Interests of bond and stock investors have been dovetailing, however. Equity investors have been showing more interest in bonds as a money-making opportunity, said Tim Kasta, managing director at Moody's KMV, a unit of Moody's Corp.
"A lot of people see credit as the new asset class or new frontier where there still look to be some mispricings," said Kasta. "Equities are very continuously traded, very liquid and it's very difficult to systematically beat the equity market."
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