Stocks Vs Bonds - How Much Leverage You Have?

When people are considering available investment options, stocks and bonds are usually popular choices. Generally speaking, bonds are considered less risky in comparison to stocks for potential investors. In most situations, that is true. Bonds are a type of long-term debt, which has covenants or restrictions that protect both lenders and borrowers. However, stocks do not have covenants or restrictions. That being the case, they are considered to be less secured and therefore more risky than bonds.

As a matter of fact, investing in stocks and investing in bonds put a potential investor in a totally different position in regards to risk as well as potential gains. Buying stock in a company means an investor owns a part of a company. On the other hand, a bond holder is a lender of the company. Under normal circumstances, a bond holder will receive his or her interest annually or semiannually. When the bond matures, he or she will receive the principal. Compared to a bond holder, shareholders or owners of a company's stock are in a more risky position. If the company is not doing well, shareholders may not get their dividends which are payouts based on earnings and other factors; or in a worst case scenario, the stock price drops, shareholders are just stuck with their "dead money." Though generally speaking these scenarios are true there are of course exceptions, one such exception is an LBO or Leveraged buyout. An LBO could be a boon for the shareholders; it could also be a nightmare for both shareholders and the bondholders of a company.

By definition, a leveraged buyout is "the acquisition of another company by using a significant amount of debt on the acquired company's books to meet the cost the acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company." A leveraged buyout will increase debt for a company significantly, which puts bondholders in a vulnerable position. What it means is that: the more debt a business owes, the harder it is for a business to pay off its debt. On the other hand, in a leveraged buyout for a publicly traded company, shareholders may have more advantages than bondholders, only if the shareholders sell the shares with good timing while the price is high. When a party or parties initiate an LBO against a targeted company, the initiating party or parties will offer a price to buy out all the stock that they do not already own in order to control the targeted company.

Usually, stock price of the targeted company goes up. That is because the investors hope the tender price will go up. If the shareholders sell their shares at this time, they can make a profit, since the market is bidding on a higher tender price. If the LBO is successful, the new company will have a high debt to equity ratio, which will affect the company's credit rating negatively. The price of the bonds owned by the company will drop therefore the bondholders will experience a loss. In an ideal scenario, after the LBO, the new owner for the acquired company will be better at managing it, will pay off the debt, or reduce the debt, and make the company profitable. Unfortunately, LBOs do not always turn out to be a story with a happy ending for the acquired company.

The initiating parties of LBO do not necessarily have the intention to lead the company to profitability. An example of this would be when Carl Icahn, who is well-known for his LBO of Trans World Airlines (TWA). Icahn sold some of the valuable assets to TWA's competitors, and left TWA with debt of more than $500 million, requiring TWA to file for bankruptcy. Icahn's goal was not to save TWA but to make a profit for himself. What he basically did was buying the shares from other shareholders and made the company his own, so that he can sell the assets and make a profit; then left the company as an empty shell with a massive amount of debt. Of course this is not something an everyday investor can do. Only the ones who have a large stockpile of cash on hand are able to close the deal on an LBO such as that and make it profitable for themselves.

Even though, leveraged buyouts do not happen every day, when they happen, only the people with deep pockets will win. As individual stock investors, we can only do our homework and play smart in the market.

Learn more, consult the CL King & Associates experts. CL King has worked as a Co-Manager for Bond Offering, Subordinated Notes Offering, Notes Offering and many more for the reputed firms such as Citigroup, Walmart, AT&T’s etc. The company transact directly in the capital markets on behalf of corporations through our Corporate Services business focused on share repurchase and continuous share offerings ("ATMs").