Do High-Yield Bonds Have an Equity Component?

Author(s): Martin S. Fridson

Source: Financial Management, Vol. 23, No. 2 (Summer, 1994), pp. 82-84
Published by: Blackwell Publishing on behalf of the Financial Management Association International
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Do High-YieldBonds Have
Equity Component?
MartinS. Fridson
MartinS. Fridson,CFA,is ManagingDirectorof HighYieldSecuritiesResearch,MerrillLynch,NewYork,NewYork.
N A controversyhas arisen concerningthe implicit equity
component of high-yield bonds. On the one hand, Reilly
(1994) reportsthat investmenthouses regardthe securities
as "low-quality creditsthathave characteristicsof common
stocks." Shane (1994) writes, "A low-grade bond can be
viewed as a hybridsecurityconsistingof a governmentbond
and a claim on the issuing firm's equity." Economist
Lawrence Summers more colorfully characterizescertain
types of high-yield issues as "equity in drag."I In sharp
contrast,Christensenand Faria(1994) deny that high-yield
debt behaves like equity. They base their conclusion on the
announcementeffect of new issues of straight(nonconvert-
ible) high-yield debt on the issuer's stockprice.
As ChristensenandFarianote,previousempiricalstudies
have demonstratedthatwhen companiesannounceplans to
sell new stock or convertible securities, their share prices
reactnegatively.In contrast,announcementsof planneddebt
issuance do not have a significantnegative impacton stock
prices.
Christensenand Faria expand upon earlier researchby
testing the impact on stock prices of announcementsof
planned offerings of bonds rated double-B or lower by
Standard& Poor's. Theirsampleconsists of 155 convertible
and 127 straightcompleted offerings, covering the period
1979-1985. They find that the convertible announcements
elicited a negative stock marketreactionbut thatthe straight
debtannouncementsdidnot. Thefindingsareconsistentwith
the conclusions of previous studies, which deal with
investment-gradebonds.
Christensen and Faria say that their results show no
"evidence thatstraighthigh-yielddebt behaveslike equity."
Upon close inspection,though,the authorsarenot examining
the behaviorof high-yielddebt.Rather,they arestudyingthe
This article is adaptedfrom the articleby MartinS. Fridson,"Does High
Yield Debt Behave Like Equity?," ThisWeekinHigh Yield(June10, 1994),
New York, NY, MerrillLynch, 4-5.
1Lewis(1989), p. 247.
Financial Management,Vol. 23, No. 2, Summer 1994, pages 82-84.
an
effect of high-yielddebt issuanceon the behaviorof equity,
which is an altogetherdifferentmatter.
Smith (1986) explainswhy a company's shareprice falls
whenit announcesanequityoffering.2Investorsassumethat
managementhas superiorinformationaboutthe company's
prospects. They furtherassume that managementis more
likely to issue stock when the market price exceeds
management's assessment of its value. Accordingly,
investorsinterpretthe announcementof an intentionto issue
equity as a sign thatthe marketis overvaluingthe company.
They respondby revising theirvalue estimatesdownward.
Smith's argument would also explain why
announcementsof straight debt financing do not have a
significantimpacton stock prices. Justas it has an incentive
to sell equity in a period of overvaluation,a company is
understandablyaverse to selling equity that is undervalued
(or fairly valued).Under such conditions,the company that
happensto have a net requirementfor externalcapital will
probably issue debt, ratherthan equity. To investors, an
announcementof a planneddebt financinglogically should
not imply that management believes the stock to be
overvalued.Investorsthereforehave no reasonto revise their
equity valuationsdownward.In short, it makes sense that
debt announcements,unlike equity announcements,do not
have a significantnegative effect on stock prices.
From the corporation'sstandpoint,the choice between
issuing equityandissuing debtis ordinarilyunaffectedby its
bond rating.3(One possible exception is the case in which
2Theliteratureis richwith hypothesesregardingthe corporation'schoice of
financingmethod. For a summary,see Norton(1991). Note thatnumerous
writers,includingSmith,emphasizethe intendeduse of proceedsas a factor
in the decision. In addition,Myers and Majluf (1984) note the importance
of assumptionsaboutwhethermanagementacts in the interestof existing
shareholdersand whetherthey, in turnadjusttheirportfoliosin responseto
management'sactions. Based on these conclusions, Myers and Majluf
derivea "peckingorder"in which companiesopt firstfor internalfundsand
then, if reconciledto externalfinancing,choose debt over equity.
3Certainly,marketconditionscan make the rating a relevant factor. In a
period of perceived high credit risk, the bond market may be open to
 BONDSHAVEAN EQUITYCOMPONENT?
FRIDSON/ DO HIGH-YIELD
the incurrenceof incrementaldebt would likely trigger a
downgrading.) If a capital-hungry, single-B-rated
company's stock is undervaluedin management'seyes, the
company will probably issue bonds. The decision is not
dependenton whetherinvestorsperceivethe debtto have an
equity component. Floating bonds is simply a more
appealing alternative than issuing undervalued stock.
Christensenand Faria'stest, in short,does not reallyaddress
the question of an equity component in straighthigh-yield
debt.
Another test, however, strongly indicates thatfrom the
investor's standpoint,thereis a sizable equity componentin
a nonconvertiblehigh-yield bond. Correlationcoefficients
consistently show that straightnoninvestment-gradebonds
trade nearly as much like stocks as pure debt instruments.
Blume andKeim (1991) reportthatin the period 1977-1990,
high-yield bonds had a monthly returncorrelationof only
0.67 with long-term governmentbonds. Correlationswith
the Standard& Poor's 500 Index of CommonStocks andan
index of returns on small stocks were 0.52 and 0.53,
respectively. SEI Capital Markets Research (1994)
calculates rolling 20-month correlationsbetween 1980 and
1992 of 0.59 between high-yield bonds and intermediate
governmentsbonds and 0.46 between high-yield bonds and
the S&P 500.
On the other hand, both of these sources report a
correlationof 0.95 betweenthe returnson governmentbonds
and investment-gradecorporatebonds. For all intents and
purposes,then,bondsratedtriple-Bor higherhave no equity
component, while bonds rated double-B or lower most
decidedly do. This difference is not negated by the fact that
the announcementof a planneddebtfinancingby a company
of any creditratinghas a neutraleffect on the issuer's stock
price.
The case for an equity componentin high-yield bonds is
buttressedby theory. (See Bookstaberand Jacob, 1986.) In
effect, a corporatebond is a combinationof a pure interest
rate instrumentand a short position in a put on the issuer's
equity. The put is triggeredby a decline in the value of the
References
Blume, M.A. and D.B. Keim, 1991, "The Risk and Returnof Low-Grade
Bonds: An Update." Financial Analysts Journal
(September/October),85-89.
Bookstaber.R. and D.P. Jacob. 1986, "The CompositeHedge:Controlling
the Credit Risk of High Yield Bondg," Financial AnalystsJournal
(March/April),25-36.
investment-grade companies but not to noninvestment-grade issuers.
Therefore,a double-B company may reluctantlydecide to issue stock at a
time when its investment-gradecounterpartsare floating bonds.
83
issuer's assets to less than the value of its liabilities. A
default,in otherwords,resultsin the stockholdersputtingthe
equity to the bondholders,who then become the company's
owners.
For a highly-ratedcompany, the put is well out of the
money. The option consequentlyhas a negligible impacton
the price movementof the bonds, which is more sensitive to
interest rate fluctuations. In the case of a
noninvestment-gradebond, however, default is a realistic
enough prospectto enablethe equityput to affect the bond's
price materially.With the equity-relatedoption exerting a
greater influence on its price movement, the
noninvestment-gradebond is bound to track government
bonds (pure interestrate instruments)less closely than the
investment-gradebond does.
Subsequent research has confirmed the equity effect.
Expandingon Bookstaberand Jacob's work, Ramaswami
(1991) reports success with a portfolio hedging strategy
"basedon the propositionthata high-yieldbondis a dynamic
combination of equity and riskless bonds." Cornell and
Green (1991) find that "movementsin stock prices explain
a largerfractionof the varianceof low-grade bond returns
thando movements in interestrates." Shane (1994) creates
an index of 208 low-ratedbonds and an index of the stocks
of the issuersrepresentedin the bondportfolio.She finds that
"significant positive correlations of the all-inclusive,
low-gradebond portfolio with the matchedequity portfolio
and with the Treasury bonds support the intuition that
low-gradebonds arehybridsecurities."
The theoreticalbasis for the equity component in the
lower-ratedbond, like the empiricalevidence supportingit,
is unaffected by the fact that announcements of
noninvestment-gradefinancings have the same kind of
impact on equity pricing as announcements of
investment-gradefinancings. I conclude that Christensen
and Faria's findings, however useful in their own right, do
not contradict the existence of an equity component in
nonconvertiblehigh-yield bonds. M
Christensen,D.G. andH.J.Faria.1994,"A Note on the ShareholderWealth
Effects of High-YieldBonds,"FinancialManagement(Spring), 10.
Cornell, B. and K. Green, 1991, "The Investment Performance of
Low-gradeBond Funds,"Journal of Finance (March),29-48.
Lewis, J., "How Bad Is the Junk-BondBacklash?"InstitutionalInvestor
(October),247-252.
Myers.S.C. and N.S. Majluf, 1984,"CorporateFinancingsand Investment
Decisions When Firms Have Informationthat Investors Do Not
Have," Journal of Financial Economics (June). 187-22 1.
84
Norton, E., 1991. "CapitalStructureand Small Public Firms,".ournal of'
Business Venturing(July), 287-303.
Ramaswami.M.. 1991, " Hedging the EquityRisk of High-Yield Bonds,"
Financial Analysts.ournal (September/October).41-50.
Reilly. F.K.. 1994.InvestmentAnalysisand PortfolioManagement.4th ed.,
FortWorth.TX. Dryden,542.
SEI CapitalMarketsResearch, 1994,High-YieldBondInvestmentsfforU.S.
InstitutionalFunds.
MANAGEMENT/SUMMER1994
FINANCIAL
Shane, H., 1994, "Comovementsof Low-GradeDebt and Equity Returns
of Highly Leveraged Firms," Journal of Fixed Income (March).
79-89.
Smith, C., 1986, "Investment Banking and the Capital Acquisition
Process."Jourinalof Financial Economics(January/February),
3-29.
Copyright @ 1994 Merrill Lynch, Pierce, Fenner & Smith
Incolporated. The infbrimationherein was obtained.fiom various
sources; we do not guaranteeits accuracy.Neithertheinformation
nor any opinion expressed constitutesan offer to buyaor sell any
securities or options orfiutur'escontracts.