Watching Credit Markets to Find a Needle in a Haystack

By: Steve Rubis

Investors are constantly in search of stocks that can make them money. Nevertheless, one of the hardest components of successful investing is generating investment ideas. Without a well developed system for finding stocks, one can feel like homeless man who panhandles for his next meal. While a system is essential to finding investments, there are many subsystems or special situations an investor can employ. Today, we would like to discuss how investors can use the credit market to find investment opportunities. Credit markets send pricing signals that equity markets often miss; this inefficient communication allows astute investors to benefit.

Many smaller investors are afraid of the credit market for two reasons: (1) it is a rich man’s game; and, (2) bond markets are too complex. Both of these premises are substantial obstacles to any investor seeking opportunity.

First, the bond market may be a rich man’s game, but it can be a great source of information. The major function of the bond market is to supply an inexpensive, in terms of equity financing, source of capital for businesses. Those who lend money in the credit market perform stringent analyses upon each company applying for credit. Analysts do their best to evaluate whether the firm has any skeletons in its’ closet that might cause it to go bankrupt. The simple fact that such thorough going analysis is performed offers investors a sense of safety. If the debt of a specific business trades at or close to par, the credit / bond market is sending a signal that the company will not go bankrupt. Conversely, if a company is on the verge of going bankrupt, credit / bond markets will price the debt accordingly.

Investors must be aware of this important pricing signal that is sent by credit / bond markets. We can extrapolate from the above premise that these prices make a strong statement about the equity associated with the debt in question. By extention, if a company has publicly traded stock, and the firm’s debt trades at or close to par, then the stock might be undervalued. On the other hand, if the firm’s debt trades at a substantial discount to par, then the stock may be over valued or a true piece of garbage.

There are few examples that illustrate how credit / bond markets can send an important signal to equity investors. The first example that comes to mind is Lucent Technologies (LU), recently purchased by Alcatel, which suffered from a severe debt burden as the Technology Bubble bursting. During the summer of 2002, Barron’s highlighted LU’s debt in an article because the value of the debt had risen from distressed levels to near investment grade. This article proved fortuitous, since over the next few months following the August article, LU stock went from roughly $1.50 to near $4. A more recent example would be Block Buster Video (BBI). During the summer, BBI was trading around the $4 range, while the debt seemed to be valued at or near par. By recent months, the stock had achieved a price as high as $5.60.

While are examples above are not world beating investment choices, they do show that investment ideas can be found through credit markets. It is important to note that more information can be found in Benjamin Graham’s Security Analysis the classic 1934 edition. The first third of the book is dedicated to credit markets and this portion of the book outlines in greater detail how credit markets can help investors sift the wheat from the chaff so to speak.