Those who regularly read my articles know that my investment philosophy revolves around exploiting the constraints and biases of the investing public. This article will focus on another anomaly you can exploit as part of your investing process. Using a company's capital structure to make investing decisions may seem complicated at first, but the concepts are pretty simple.
Academic research shows that companies with bonds outstanding that are rated as junk by the major rating agencies tend to underperform over time (here's an overview of credit ratings for those who would like one). What's even more interesting is that the dramatic underperformance of stocks with poor credit ratings in the aggregate tends to manifest itself in sudden/dramatic fashion. This leads to the risk of owning them being underpriced.
The best analogy to this phenomenon is thinking of junk-rated stocks like they're desert gulches. They're safe to be in most of the time, but susceptible to sudden and devastating events.
Understanding Capital Structure
Most publicly-traded companies have some combination of debt and equity available to trade. Typically, the debt is issued as bonds and the equity is issued as common stock, although there are dozens of ways to set up the capital structure of a company. This gives you a choice of where exactly to deploy your cash in any given company.
If this is elementary to you, feel free to skip to the next section!
Capital Structure: The Basics
In a nutshell, bondholders are owed their principal and interest before equity holders are entitled to any share of the company's profit. If a company can't meet its debt obligations, bondholders are allowed to liquidate the company to recoup their principal and interest. On the other hand, if a company succeeds, shareholders are fully entitled to enjoy the profits without having to share with the bondholders.
- Senior debt is the preferred method used of most companies to fund their operations.
- Mezzanine debt is less common but gets paid off after senior debt, so it's usually more expensive for the company. Because it's more expensive, most companies that issue mezzanine debt are either speculative or can't get a better deal elsewhere.
- Convertible debt is debt that can be converted into equity, usually at a fixed price. Like mezzanine issuers, most companies that issue convertible debt are junk-rated.
- Preferred stock is often issued by financial institutions like banks and insurance companies. If a company gets into a tight financial spot, they can often suspend the preferred dividend and pay it later (preferred shareholders still have to be paid before a company can issue a dividend or buy back common stock). Sometimes, companies will try to get tricky with preferred stock, so extra due diligence is required if you want to invest (here are some examples of what can go wrong).
- Common stock is what most people think of as stock. Companies can raise equity capital if they want to, but it's almost always more expensive to sell shares and dilute existing shareholders than it is to issue debt.
The junk credit rating anomaly
If presented with a new investment opportunity, private or public, one of the first things you should do is look at the capital structure of the deal. Who is investing? Who has seniority in terms of cash flow?
You should be very cautious about any investment where a group of sophisticated investors is senior in the capital structure to a group of unsophisticated investors. This is easier to find in the stock market than you think. This scenario is common in companies cannabis stocks, biotech stocks, and even more established but hype-heavy companies like Tesla (TSLA). Research shows that the greater the perceived conflicts of interest of management in a company, the worse the market reaction to changes in the capital structure of a company, especially when the impact is not easy to quantify.
It's a little tough to know if the aggregate poor performance of stocks with non-investment grade debt outstanding is due to the type of debt issued (i.e. convertible vs. senior) or due to the credit rating of the company. It's likely that the effect is due to a little of both causes.
Standard & Poor's did a study on the stock returns of companies with investment-grade credit vs. companies with junk-rated credit between 1989 and 2009.
From a Forbes article on their study:
Over the period 1989-2009, the investment grade companies beat the speculative grade companies' average annual return by a whopping 10.11% to 5.62%. The striking thing about this disparity, aside from its magnitude, was that the investment grade companies achieved their superior performance with less risk than their speculative grade counterparts. Using a standard risk measure, they reported that the standard deviations of returns were 18.35% and 26.06%, respectively.
This was independently confirmed by a Yale study in conjunction with AQR Capital Management, a large Connecticut-based hedge fund whose research I enjoy. I've also covered how quality companies beat junk companies on several occasions, most recently in my piece on how low volatility ETFs crush the S&P per unit of risk taken.
If the companies are so low-quality, you'd think their debt would perform poorly too, right? Actually no, the debt does better! The debt of low-quality companies actually performs better than equity as far as absolute returns go, and much better on a risk-adjusted basis. This is fairly intuitive because after all, bondholders get paid before shareholders. Risk-adjusted stock returns steadily drop the further down the credit rating scale you go.
And you'd be surprised what the credit ratings of popular companies often actually are when you go to check them. AT&T (T) was downgraded to BBB after its acquisition spree. GE (GE) is BBB+. Tesla is B-, which is straight up junk. Commonly, rating agencies seem to leave the ratings of large corporate employers one or two notches above junk, likely to avoid causing harm to these kinds of large and politically favored companies. Ford (F) and General Motors (GM) are good examples of this. I'm not the only one to think this, either. There's been a good deal of research done on the growing segment of companies rated a notch or two above junk. This means there's a lot of debt out there that likely has the risk profile of junk but is rated a notch or two above.
From a recent Wall Street Journal headline:
There Have Never Been So Many Bonds That Are Almost Junk."
On the other hand, companies like Apple (AAPL) and Microsoft (MSFT) have AA or higher ratings. Most of the market cap of the S&P 500 has A or higher rated paper. There's really no need to invest in lower-quality equities. You can read more about the credit profile of the S&P 500 here.
S&P 500 Credit Profile
Source: S&P Global
Credit ratings are a big deal for S&P 500 components, but for smaller companies, getting locked out of the investment-grade debt market can crush their ability to compete in the marketplace. Tilting towards quality is even more important in small-cap stocks.
How to profit from this anomaly in Tesla and Netflix
I can think of several stocks off the top of my head where there are mainly sophisticated investors holding the bonds and mainly retail investors holding the equity. Tesla's institutional ownership is under 60 percent and their short interest is about 20 percent. That's not a great ratio. They've been able to defy critics so far, but the valuations on the debt vs. the equity make it easy to evaluate whether the debt or equity is a better opportunity.
Cannabis stocks also immediately come to mind in this category, but I wouldn't even touch their debt in most cases. Tesla is a good example of a company that probably will be good enough for bondholders but not for shareholders. To like Tesla's cars is one thing, but to want to own their common stock, you're implicitly saying you like their capital structure.
Tesla's debt has gotten cheaper over time, whereas its equity has gotten more expensive (and diluted).
Tesla 5.3 percent 2025 senior bonds
Source: Markets Insider
As you can see, Tesla's 2025 bonds are trading for 88 cents on the dollar and pay $5.30 in coupon per year for every 100 dollars invested. The yield to maturity is about 7.5 percent.
The question I would ask is why would anyone choose Tesla's common stock when you can get a 7.5 percent return that's guaranteed before common shareholders get a penny in profit from the company? Remember that Tesla continually needs to borrow money to run the company. You have, in my opinion, a sophisticated group of bondholders who are senior in the capital stack to a very idealistic shareholder base that could likely be persuaded to buy more stock in the future if Tesla needs help meeting their debt obligations. I like the price for these bonds and think they'll pay off in full, even if Tesla common shareholders suffer for it.
Netflix (NFLX) is another great example.
Netflix 2025 5.875 percent bonds
Source: Markets Insider
Netflix has been more successful in developing its business model than Tesla in the eyes of the bond market. These bonds were issued in 2015 and carried a coupon just shy of 6 percent. Now they're trading for 106+ cents on the dollar, giving bondholders over a 7 percent return on their investment for the time period. Bondholders have been able to participate in the company's upside while remaining senior to equity holders who are betting on Netflix's ability to compete with Hollywood and pay off the debt holders in full before they receive any profit. I also like these Netflix bonds as an alternative to the common stock. They pay 4.3 percent to maturity currently, and Netflix's rapid subscriber growth has made them an increasingly safe bet.
Remember that the downside for these kinds of stocks is often quite sudden. Tesla and Netflix are two of the biggest winning stocks that have junk credit ratings. For every Netflix out there, there are 5-10 times as many companies whose post-IPO returns are mediocre like Twitter or disastrous like Snapchat (SNAP) or GoPro (GPRO).
For this reason, I'd recommend that anyone who has either Tesla or Netflix stock consider swapping their stock for their respective junk bonds.
To take advantage of these opportunities, you can trade these bonds through your online broker. Etrade, Fidelity, Vanguard, and Interactive Brokers will all allow you to trade bonds. Be mindful of transaction costs and use (very patient) limit orders if allowed by your broker, knowing that sometimes it will take hours or days for you to get the bond price you're looking for.
You're not likely to get strong returns over a long period of time by investing in companies with junk-rated debt. In fact, with the majority of new technology, biotech, or cannabis related opportunities, you're likely to lose big once the companies are forced to roll over their debt.
Investors are biased towards high beta stocks due to the success of a few outliers and are willing to take a chance to potentially get a long-shot payoff. By doing so, they collectively overestimate the chances of success for speculative-grade companies compared to investment-grade companies. If you are thinking about investing in companies like these, look at the capital structure and consider investing in their junk debt instead of common stock.
This strategy has been shown to deliver superior absolute and risk-adjusted returns over long periods of time. You can allocate to the equities of high-quality companies and the debt of lower-quality companies and increase your overall return with lower risk. While these junk bonds won't fit in every portfolio, they help illustrate an important point about the capital structure of companies and how you should think about positioning yourself in these situations.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.