Friday, October 10, 2008

why bonds matter

I have been incessantly promoting the idea that the government must fix the price for corporate bonds or face a true collapse in companies and their shares. even though the corporate bond market is only 1/3 the size of the stock market, it's actually much more important.

why? equities are leveraged to debt. if bonds fall a little, stocks fall a ton.

consider these examples:


equities represent the "residual value" of a company after the bondholders are paid back. furthermore, bonds have to be repaid on certain dates -- unlike stock. so, when debt comes due, the CFO must find the money or declare bankruptcy. and, if bond investors don't want to buy more bonds from the issuer, companies cannot roll over their debt. that means they must either sell assets, use existing cash, cut dividends, or SELL MORE STOCK. none of those choices are good for shareholders.

this is what's happening in the bond market right now. companies are incapable of rolling over debt. so far, the effort has only focused on the short-term commercial paper market. I argue it would be better to fix the long-term corporate bond market because if companies can term out debt for 3+ years, they don't need to roll it over every 30 days. it's scary that the shutdown of the long-term market is forcing more debt into the short-term market at the same time banks are collapsing and incapable of lending. it's different from the 2002 recession when the debt market remained open for most issuers, aside from the failing telecom and utility names. now it's shut for almost everyone. this is also scary because corporate America currently relies more on the debt markets to run operations than in the past.. see my posting below.

excluding debt issued by asset-backed trusts, there was about $7.2 trillion of corporate bonds outstanding at the end of 2007, and about $21.8 trillion of corporate equities outstanding, according to the Fed. that 3:1 ratio has held roughly steady over the last decade or so.

that implies if the bond market loses $100bln of value, more than $300bln of equity will get wiped out. this is why the only way to save the stock market is to unfreeze the bond market. otherwise, we'll all wind up looking like Charter Communications:

THE TIME TO ACT IS NOW. THE PLACE TO ACT IS IN THE TERM CREDIT MARKET. THAT IS WHERE THE GREATEST DANGER LIES.

(this also poses long-term dangers to leveraged companies like AT&T and Verizon. when their interest rates inevitably rise, they will have less money to pay dividends.)

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