As most of our clients know, we invest our collective money across the entire capital structure of companies. The capital structure of a company is comprised of all the securities they issue to make up their capital: bank debt (at the top), bonds, convertible bonds, preferred shares and finally stock/equity (at the very bottom). So if we like a company, we are going to invest in that part of that company's capital structure that we feel will provide the best risk-adjusted returns. Buying stocks is not the only way, and usually not the best way, to garner the best risk-adjusted returns.
Below I will show a good example of a Canadian oil producer (Baytex Energy) that has both stock and bonds (I will use just a C$ bond in this example) outstanding. Here you go, with an explanation to follow:
Ok, here is the explanation on this busy chart:
Things to notice from this chart:
It is #4 that has me thinking. Usually, like back in 2015 when oil was getting hammered, it was the underlying high yield bonds that traded lower in advance of the underlying stocks. Remember, bonds (both government and corporate) tend to lead all other markets, including stocks.
So what does it mean that the underlying high yield bonds of these oil producers, like BTE, are not selling off, either in advance or concurrently? Will they sell off after the fact and actually lag the underlying stocks? Or are the stocks now really, really cheap? And what about the price of oil...up, down, sideways?
I am still in thinking mode on this one so, I have no definitive answers for you on the above questions. I will, but not right now.
And here are the Total Returns for these securities from 12/30/2016 thru 06/08/2017 (YTD on a daily basis as per Bloomberg) so we can get a better picture:
Now the reason BTE stock, and any other oil producer, would be down as much, or more, than the actual price of oil is quite simply because they have leverage (debt) and that produces operating leverage which exacerbates the moves up and down vs the price of oil. In this case, to the tune of 3x more than the price of oil.
But BTE's underlying bond? Price hasn't really changed and, including the almost-six-months of coupon, it is actually +2.86%. Who says you can't make money in bonds?
So I will put my thinking cap back on and figure out if BTE stock is super cheap or these bonds are super expensive. As is always the case when investing in companies, especially in commodity-related companies, we need to get the call on the commodity right first. That is the key.