Friday, October 14, 2011

Credit Markets Are Not Confirming the Equity Market Rally (Short Squeeze)

When equities go up or down - whether single companies or as a class - bonds are supposed to follow, because both sets of prices reflect an embedded set of assumptions about companies' profitability and solvency. Any exception, or divergence, from this rule is noteworthy because it means that either the equity investors or the bond investors are making a mistake.

Since the low on October 4 there has been an 11% jump in the S&P 500 and closer to 17% in the Russell 2000. But the enthusiasm hasn't really carried over into the distressed corporate credits that I follow. I have two good examples of this.

First is USG Corp, our favorite manufacturer of wallboard. The market cap is $900 million but the company has $1.7 billion in net debt. Over the past twelve months they have earned a paltry $43 million in EBITDA, versus an interest expense of between $150-200 million. As cash gets burned, tangible book value is steadily declining, leverage is increasing, and the bond yields have been rising. All the symptoms of a company that is going to be restructured with more equity ownership going to bondholders.

Since the October 4 low, USG common has rocket up almost 40 percent. Meanwhile, the company's 6.3 percent notes due 2015 have not really budged, continuing to trade in the low 70s with lackluster volume. The wallboard industry added so much capacity during the housing bubble that they can probably only achieve profitability during bubbles now.

Second example is uranium enrichment company USEC (USU). This is a long story but the company is distressed because it has been in limbo on a $2 billion DOE loan guarantee needed to complete a massive new uranium-enrichment plant in Ohio. It's unclear why the DOE would be stonewalling, but that seems to be what is happening.

Just today, the USU common shot up over 50 percent! But the company's three percent note due 2014 was basically unchanged from its mid-50s level, and not that many bonds changed hands.

This is all typical of the structural stupidity (excessive optimism) that we see in the equity market. But it also suggests that the equity moves we are seeing are short squeezes and not fundamentals-driven.

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