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Can bad news for shareholders be good news for bondholders?

01 March 2019

If a company has a strong balance sheet and profits are growing, we would expect to see the equity price rise and funding costs for the company decline. This would result in a narrower credit spread, which would benefit previously issued bonds. Whilst the focus of bondholders and equity investors may differ, they are typically aligned with the fortunes of the company. However, this week we were reminded that this is not always the case.

Marks and Spencer announced a rights issue to fund a joint venture with Ocado for an online delivery platform and cut its dividend. The rights issue and cut in dividend caused the share price to fall. Bad news for the shareholders. Meanwhile, bond prices rallied as the cut in dividend and potential increase in sales were seen as improving future cash flows reducing the likelihood of a credit rating downgrade. Good news for bondholders. Protecting the credit rating at a cost to shareholders is not uncommon practice. Companies that have high debts need to defend the credit rating to prevent borrowing costs from rising. Consequently, during times of stress, rather than borrowing more they may issue more equity. This improves the balance sheet, credit rating and the long-term viability of the company, but in the short term will dampen the share price as the shareholders interest becomes diluted. A company that is expanding rapidly may use debt to buy back its equity in order to boost its share price. This debt issuance is likely to increase its funding costs pushing existing bond prices even lower. Meaning that it is possible to hold a positive view on a bond and a negative view on the equity and vice versa.  

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