Coal Bonds Provide Clues For Equity Investors

by: The Financial Lexicon

Not all sell-offs are the same. For quite some time, coal stocks have been getting absolutely crushed. Peabody Energy (BTU) is trading 54.91% below its 52-week high, and Alpha Natural Resources (ANR) is down a whopping 75.24% from its 52-week high. Arch Coal (ACI) and Patriot Coal (PCX) are also stuck in the midst of ferocious selling, down 76.24% and 78.12% respectively from their 52-week highs. As I noted in my March 6, 2012 article, "Buying The Dip In Coal With Select Bonds," the bonds of many coal companies were following the stocks lower and were worth considering over the stock for those interested in investing in coal companies and who were comfortable with the yields offered at that time.

In this article, I'd like to point out that the bonds of the four aforementioned coal companies have diverged in terms of price direction. Two of the companies have bonds that have rallied and the other two have bonds still testing 52-week lows. The divergence can be traced to mid-to-late April and should offer equity investors in coal stocks a bit of insight into the risk level associated with buying the bottom of the capital structure, the common stock.

On April 10, Peabody Energy's stock reached its 52-week low of $27.11, which has, up to this point, still held. Peabody then rallied from that day's low to $31.97 on May 1. Alpha Natural Resources rose from its April 10 low of $13.80 to $17.30 on April 20. Along with the rally in the stocks, the two companies' bonds also followed suit.

Two examples are the following: Peabody Energy's 9/15/2020 maturing, 6.50% coupon bond (CUSIP: 704549AH7) rallied from 98.25 on April 9 to 107 on May 1. Alpha Natural's 6/1/2019 maturing 6% coupon bond (CUSIP: 02076XAB8) jumped from 88.20 on April 10 to 97.30 on April 20.

Now here is the interesting thing: since the stocks topped out from the rallies off the April 10 lows, they've resumed selling off. Peabody is once again trading under $30, and Alpha Natural has actually broken through its April 10 low, recently closing at $13.67. However, this time, the bonds haven't followed suit. Both Peabody's and Alpha Natural's bonds are trading roughly in line with the prices they were at when the stocks topped out on May 1 and April 20 respectively. I should note, however, that on Tuesday, May 8, Alpha Natural's CUSIPs 02076XAB8 and 02076XAC6 showed a bit of weakness on the bid/ask. This weakness was not easily discernible just by looking at the day's highs and lows because large dealer markups created highs for the day that weren't warranted based on where the market was trading.

Contrary to the experience of Peabody Energy and Alpha Natural Resources, Arch Coal and Patriot Coal's bonds are still testing their April and 52-week lows. Not surprisingly, given the performance of the bonds, Arch Coal's stock couldn't even manage to put together a solid mid-to-late April rally. Patriot Coal's stock did manage to rally 28.60% from April 10 to April 20 but its 4/30/2018 maturing 8.25% coupon bond (CUSIP: 70336TAC8) simply couldn't gain any ground and is still trading around those April lows. Also not surprisingly, given the weakness in the bond, Patriot Coal's stock quickly lost its entire 28.60% mid-April gain and actually dropped 6% below its April 10 low on May 7.

It seems to me that despite the continued selling pressure we are seeing in each of these four stocks, the bond market is sending the following message: regarding Peabody Energy and Alpha Natural Resources, the industry-specific issues that caused the bonds to sell off in recent months are no longer at the forefront of bond investors' minds. In other words, the "known unknowns" and "known knowns" have been priced in, and going forward, the bonds should trade more in line with the overall market. Furthermore, I would argue that equity investors concur, especially with regard to Peabody Energy. Peabody has outperformed the S&P 500 (NYSEARCA:SPY) over the past month by roughly 6% and seems like it wants to go higher. It just needs a little help from the major market indices, which I believe are holding it back at this time.

Alpha Natural Resources' stock isn't quite exhibiting the same strength as Peabody's stock, underperforming the S&P 500 by approximately 1.5% over the past month. This is actually about the same underperformance that Patriot Coal's stock has experienced. However, given the behavior of Alpha Natural's bonds, if I were to choose between ANR and PCX's stocks, I'd be inclined to give the benefit of the doubt to the company the bond market seems to favor and go with Alpha Natural Resources.

Keep in mind that even if you are only interested in equities, following the bonds of the companies whose stocks you are interested in buying can provide you with an additional tool for trying to determine the strength of a down move in the stock or whether there may be an opportunity to get long. I know there are many equity investors who favor just using fundamentals to determine when it's time to buy a stock. I also know there are many investors in the equity markets who believe that using technicals is the way to go when determining an entry point for a stock. I like to think of using the bonds as a tool for gauging when to buy the stock as a mix between the fundamentals and the technicals. It uses the wisdom of corporate bond investors, investors focused on the credit risk of a company (fundamentals), to look for divergences (technicals) between different levels of the capital structure of a company.

Of course, there are times when a company's stock might be justified to sell off while the bond's price doesn't follow. One example might be when earnings growth is slowing to an extent that the equity multiple contracts, hitting the stock's price. While finding the divergence between the different levels of the capital structure isn't the Holy Grail in terms of helping equity investors know exactly when to buy or sell a stock, it can at least help stock investors make a more informed decision about the severity of risks facing a company.

Disclosure: I am long BTU. I am long CUSIPs 704549AH7 and 02076XAC6.