Somebody Is Very Wrong About Nokia

Jun.14.12 | About: Nokia Corporation (NOK)

In the wake of Nokia's (NYSE:NOK) latest announcement about actions "aimed at sharpening its strategy, improving its operating model and returning the company to profitable growth," the stock got crushed, falling to a new 52-week low. While many investors may be focusing on the seemingly never-ending decline in Nokia's stock, the bonds are sending a message as well.

Nokia's senior unsecured notes are currently trading at yields that indicate the rating agencies are very wrong in their ratings-and not in a good way. In other words, the market is saying the rating agencies are rating Nokia too high. At the moment, Moody's rates Nokia's senior unsecured debt Baa3, the lowest investment grade rating available. S&P and Fitch have BB+ ratings on Nokia's debt, the highest junk rating a bond can receive. Currently, the "BofA Merrill Lynch US High Yield BB Option-Adjusted Spread" is at 4.99%, while the BBB spread to Treasuries is at 2.83%. Nokia's 5/15/2019 maturing, 5.375% coupon, senior unsecured note, CUSIP 654902AB1, is currently asking 905 basis points more than a comparable Treasury, while the 5/15/2039 maturing, 6.625% coupon, senior unsecured note, CUSIP 654902AC9, is asking 653.5 basis points more than a comparable Treasury. These spreads are far in excess of what a correctly rated Baa3/BB+/BB+ corporate note should be trading at given current market-wide spreads.

In terms of yield, the aforementioned Baa3/BB+/BB+ rated seven-year Nokia bond is yielding 10.095%. One example of a bond with similar ratings and call features to Nokia's notes is Peabody Energy's (BTU) 9/15/2020 maturing, 6.50% coupon, senior unsecured note, CUSIP 704549AH7, currently trading at par. This bond is rated Ba1/BB+/BB+. There are many corporate bonds with similar ratings and call features to Nokia's I could use to illustrate just how far off the ratings agencies are from what the market is pricing in. I hope that choosing one from the coal industry, an industry that in recent months everyone loves to hate, will further help drive this point home.

The steel industry is yet another example of an industry investors love to hate. Despite this, U.S. Steel's (NYSE:X) 4/1/2020, 7.375% coupon, senior unsecured note, CUSIP 912909AF5, with its B1/BB/BB- ratings is yielding 1.698% less than the Nokia 2019 maturing bond. Chesapeake Energy (NYSE:CHK) is another company in the news of late for all the wrong reasons. Given all the negativity surrounding this company in recent weeks, combined with the fact that its senior unsecured notes are rated Ba3/BB-/BB- respectively by Moody's, S&P, and Fitch, multiple notches lower than those of Nokia, perhaps you would expect its bonds to be yielding more than Nokia's. That would be incorrect. None of Chesapeake's senior unsecured notes are yielding more than 7.40%, which is much lower than the comparable Nokia bond.

The bond market is clearly sending the message that an investment in Nokia is fraught with risks. But, this doesn't mean there aren't opportunities for investors in Nokia. While equity investors might be tempted to trade a bounce and options traders have the opportunity to collect hefty premiums selling out-of-the-money puts on near-term expiration dates, bond investors also have an opportunity. If you believe that a worst case scenario for Nokia would be a buyout of the company prior to bankruptcy, the chances are quite high that the senior unsecured notes would assume a rating equal to, or quite close to, the rating of the acquiring company. If Microsoft (NASDAQ:MSFT) is at the top of the list of potential acquirers, then Nokia's current Baa3/BB+/BB+ rated notes could eventually become Aaa/AAA/AAA rated notes, assuming Microsoft maintains that coveted rating.

At the moment, Microsoft's 6/1/2019 maturing, senior unsecured note, CUSIP 594918AC8, is yielding just 1.661% and is trading at a spread of 61.6 basis points over a comparable Treasury. Nokia's 2019 maturing note is trading at a spread of 843.4 basis points to Microsoft's 2019 maturing note. If Microsoft ever acquired Nokia prior to a default on Nokia's bonds, that spread would collapse, providing significant upside for Nokia's bond investors. This could happen despite the fact that the takeover price on the equity could be at levels equity investors would abhor. In other words, by purchasing Nokia bonds at current yields, investors can benefit not only in the event of a successful turnaround but also in the event of a takeover.

While it's hard to know with absolute certainty how the Nokia story will end (bankruptcy, takeover, turnaround), there is one thing we can say with certainty: Somebody is very wrong about Nokia. Either the rating agencies are wrong with their current ratings or the market is wrong in how it is pricing Nokia bonds. Whom do you believe?

Disclosure: I am long BTU.

Additional disclosure: I am long CUSIPs 912909AF5 and 704549AH7. I am also long Chesapeake Energy bonds.