Bonds Win and Stock Screw

One important fact about recent market turmoil is that while it has its roots in troubled debt, it is stock investors who usually pay the price for a company's missteps. Bank of America agreed to buy Countrywide Financial at a huge discount, ensuring Countrywide's lenders would get paid back. But shareholders were left down more than 80%. J.P. Morgan Chase swallowed Bear Stearns in a fire sale that staved off bankruptcy, good for bondholders but, again, bad for stock investors. Bond insurers MBIA and Ambac Financial Group issued stock to build needed capital, helping their debt while diluting the stock. Thornburg Mortgage avoided default in part by issuing warrants to purchase its common shares, which will dilute shareholders. The stock is 95% below its 52-week high. Lehman Brothers Holdings and UBS unveiled plans to raise capital by issuing new shares. Stock investors celebrated, even though it watered down their shares. "The debtholders have done extremely well because the company either sells itself at a discount or issues enough equity to put off a bankruptcy," says Boaz Weinstein, co-head of global credit trading at Deutsche Bank. He's searching out financial companies with bonds that look beat up relative to their shares, and buying the bonds while shorting the stocks. Another example: Ruby Tuesday, the restaurant chain, which reports earnings Wednesday, avoided default by asking lenders to change loan agreements and cutting its dividend. It's supposed to work this way. Creditors are first in line to get paid when problems emerge. Shareholders are the end of the line. Yet the broader market doesn't seem to reflect this trend. True, even after Tuesday's rally, the Dow Jones Industrial Average is down 11% from its record high. But corporate bonds have also been trounced. Junk-bond defaults are still low, but the yields demanded by investors have soared. "Credit has decoupled from equities," wrote Bank of America credit strategist Jeffrey Rosenberg in a Monday note. He favors high-grade corporate bonds to stocks. Because stocks are a riskier asset class than bonds, they tend to do better when times are good, paying investors for their willingness to take risk. But when times are tough, shareholders suffer. If the market starts pricing that in, the much-maligned bond market might be the safer place to be while Wall Street scrambles to raise money.