Stocks & Bonds: It takes two to Tango

The sum total of all money in the financial markets is either tied in bonds (debt instruments) or in equity. The amount of bits and bytes that is dedicated to equity, not even a fraction of that finds a passing mention in the case of bonds; whereas the size of the bond market is almost twice that of the equity markets and it has been so for a long time.

 

How does the equity funding happen? It happens largely from the bond market. So as the equity markets have grown, so have the bond markets. 

 

This is because no one is buying equity with equity, instead equity is serviced by the debts that are taken; if a company wants to buy back its own stocks from the common equity holders it is not going to do so by using its reserves and surplus. Instead it would access the debt markets, sometimes issuing corporate bonds, to be able to generate funds for buying back its own equity. Some global companies do not want to bring back profits from subsidiaries to their parent, so they are in any case short of cash to fund buy-backs. 

 

What is the logic for buying back own stocks from the market with debt instruments like bonds?

 

Take a star performer that increases its top line by a healthy 10% and the bottom line by 20%, it is an ideal ground for stock buy backs as in this company the reserves will be growing at much higher rate than what can be put to any good use for investment in the same line of business. If the reserves are put to the usual treasury fixed income portfolio, the returns remain low. The only other solution to this problem is conglomeration and diversification but that carries a high risk.

 

Buying back equity with funds generated out of bonds makes enormous sense if the situation is as above, especially when the interest rates are low.

 

In the markets where we tread, it makes enormous sense as debt markets have remained far more attractive given where the interest rates are; so when corporate bonds at fixed rate of return are weighed against the prospects of a rising equity return, the latter creates an enormous delta. The more this happens the more the delta surges, somewhat like a bubble. 

 

The hedge funds actually remained short on treasury while they moved long on equity, as the underlying conditions had interest rates stuck at the zero lower bound.

 

In recent times concentration of equity exposure in a small basket of high performing stocks seems to have replaced the well tested discipline of a distributed portfolio. This almost  resembles the building of a tail risk, which has very high performers in very low numbers stacked against the other end of the pole, which is a large number of very low performers. 

 

The concentration is mind boggling that out of a quarter of a million firms that operate in the equity markets globally, only the top 500 make about 50% of the global market capitalization (outside of China).  Isn’t it unnerving that all the global shine is limited to the very few whose economic contribution measured in book value of their stocks is a fraction of the market value they command?

 

The book value of a stock in a company is Assets minus liability of the company divided by the number of shares. So when you use the debt instruments to fund stock buy-backs, the numerator surely comes down and the book value diminishes. But on the other hand the denominator also changes as the number of shares outstanding comes down.

 

But look at what happens on the market value of the equity with stock buy-backs. It goes up disproportionately as the market value of an equity is governed by the Earnings (E) per share (S), so when the number of shares outstanding comes down the ratio E/S goes up.

 

This belies somewhat the principles of investing, which in its basic form must pass the acid test of sustainability; given that a very small segment – high performing companies with no other avenues for cash investments, has investors attracted to them by virtue of the promoters spreading the general belief that their stocks are under-valued and should be therefore good opportunity for investing.

 

It is almost like saying that the promoters know more than the general market, leading the market into believing what the promoters believe. It should be the other way round.

 

Be that as it may, the entire global investing community has fallen for every company that has gone for stock buy-backs. I do not know whether this falls in the category of cognitive dissonance. 

 

The bond market on the other hand had grown disproportionately.

 

It takes two to tango as always.