How corporate events affect the value of stocks and bonds

After finding a company that looks very suitable for investment and understanding the business and financial situation, investors usually choose which type of investment to make. Stocks are investments in which investors have ownership interests in a company. Bonds allow investors to borrow money from companies and charge interest.

Let’s take a look at how these very different investments are affected by corporate events.

Investment as a shareholder

Shareholders own part of the shares in the company in which they invest.Stocks are traded on exchanges, and prices are determined by the market. Stock prices are usually driven by financial performance, company news, and industry fundamentals. They are usually valued on the basis of “multiples”.

Stock investors usually invest in companies that they believe have superior growth prospects but are undervalued by the market. Although the market determines the stock price, shareholders can influence management and company decisions through proxy voting. Shareholders will only receive “payments” from their investments when the stock price rises or when dividends are paid.

(For more information, please view What it actually means to own stocks.)

Investment as a bondholder

Bondholders are different from shareholders because they do not have any ownership in the company. On the contrary, bondholders essentially borrow money from the company based on a set of rules/objectives (contracts) that the company needs to comply with in order to maintain a good reputation with bondholders.Once the bond matures, the bondholder will recover the principal investment from the company. At the same time, they will receive a coupon (or interest) payment on the bond (usually once every six months).

READ ALSO:   The world's largest ETF

Corporate bonds are traded in the bond market, and prices are based on the financial fundamentals of the company that issued the bonds (most notably the strength of the company’s balance sheet and the company’s ability to repay debt). Bonds have an inverse relationship between price and yield, so bonds are sold at a premium when the risk is low (that is, the coupon is low), and sold at a discount when the risk is high. The principal does not deviate, so it is called the face value, but the coupon and price will vary according to the perceived financial strength and investors’ expectations of the company.

Bonds are rated by rating agencies (such as Standard & Poor’s, Moody’s, and Fitch) based on their characteristics. When any of these institutions changes its rating, market prices will fluctuate. Therefore, bonds are also vulnerable to market speculation on rating changes. Investment-grade bonds are generally considered to be free from financial failure, while high-yield bonds are much more risky.

How corporate actions affect shareholders and bondholders

The company faces many decisions that affect investors. One of the biggest conflicts between investors and companies is that what is good for one stakeholder may be bad for another stakeholder.

Let’s take a look at some situations that may benefit or harm the positions of stock and bondholders.

1. The company borrows money to expand

When a company borrows funds, shareholders’ earnings per share (EPS) are negatively affected by the interest that the company must pay for the borrowed funds. However, the borrowed funds will not dilute shareholders’ holdings by increasing the number of outstanding shares, and may benefit from the increase in sales revenue brought about by the expansion. On the other hand, bondholders may face the problem of a decline in the value of their investment because the company believes that the risk increased due to the increase in debt burden. Part of the increased risk is that debt may make it more difficult for companies to pay debt to bondholders. Therefore, under typical circumstances, the stock price of a company will be less affected than a bond when it borrows money.

READ ALSO:   Maximize your actual return on retirement

2. The company repurchases shares

When a company announces a stock repurchase, shareholders are usually happy with the announcement. This is because stock buybacks reduce shares outstanding, so profits are spread across fewer stocks, resulting in higher earnings per share, and generally higher stock prices.On the other hand, bondholders are usually dissatisfied with such announcements because it cuts the company’s cash on hand and reduces the attractiveness of the balance sheet. Therefore, under typical circumstances, stock prices usually react more positively than bond prices.

(For more insights on when buybacks will benefit investors, please see 6 distressed stock repurchase scenarios.)

3. A company filed for bankruptcy

When a company files for bankruptcy, stocks usually fall sharply. The company’s bonds are also facing a sell-off, although the extent of what happens depends on the circumstances. The difference in the degree of negative reaction between stocks and bonds is that in a company’s stakeholder list, shareholders have the lowest priority. Bond holders enjoy higher priority and obtain a higher proportion of investment funds according to the type of bond investment (guaranteed to sub-prime). Therefore, in this case, bond prices will usually perform better than stock prices.

READ ALSO:   4 ways to hedge against the next recession

(Learn more about how a company went bankrupt Corporate Bankruptcy Overview.)

4. The company increases its dividend

When the company increases its dividend, shareholders will receive a higher dividend. On the other hand, as companies reduce their cash on hand, bonds are under pressure because this may interfere with their ability to pay bondholders. Therefore, stocks generally reacted positively to this announcement, while bonds may react negatively.

(For more information, see Dividend facts you may not know.)

5. The company increases the credit line

When the company increases the credit line, the stock is usually not affected. At best, stocks may respond positively because the company will not try to issue new shares and dilute existing shareholders. However, bonds may react negatively because it may indicate that the company is increasing borrowing. However, if there is a cash crunch in the short term, it may mean that the company can repay short-term debt, which is beneficial to bondholders.

Bottom line

Any potential investment should be based on the company’s fundamentals, while considering the possibility of various situations or scenarios that may affect investors. After finding a company that meets your investment criteria, you need to decide whether to invest in bonds or stocks. Constantly reviewing investments based on changing company decisions is an essential part of any investment strategy.

(For more information, see Corporate Bonds: An Introduction to Credit Risk.)


Share your love