Bond investors acutely attuned to a company’s financial health

NEW YORK » Given Wall Street's hair-trigger propensity for punishing a company's stock for bad news -- and over-inflating the price for good news -- it's become harder to use share price as a useful indicator of a company's overall health.

Corporate bond prices, however, could provide a more complete picture of a company's prospects. Unlike stock investors, who tend to jump on and off a company's bandwagon quickly, bond investors have a more long-term approach. And that makes bond trading data a sound tool for assessing a stock investment.

"The presumption is the bond market is smarter than the stock market," said Ken Tower, chief market strategist for Schwab's CyberTrader. "I'm not saying it's always true, but there's a reason that the bond market tends to lead the stock market."

In their simplest form, corporate bonds work like Treasury bills or municipal bonds. A company sells notes to an investor, promising to pay interest over the life of the note, and to repay the principal at the end. Those bonds can be traded like stocks, with the price fluctuating based on the company's fortunes.

Unlike stock, investors do not own a piece of the company through corporate bonds. They've simply lent the company money. And just as a bank would weigh a customer's ability to pay a mortgage, bond investors weigh a company's ability to pay up when the bond matures.

That confidence translates directly into corporate bond prices. Bonds will fall if appears the company's finances are stretched -- even if the company's stock price goes up.

For example, General Motors Corp.'s stock price surged 18 percent on May 4 after billionaire investor Kirk Kerkorian announced he would purchase up to 28 million shares of GM stock. Kerkorian's motives were unclear at the time -- was he purchasing to gain majority control, or just investing in what he believed was a fundamentally good company? For the stock price, it didn't matter. Pure supply-and-demand economics pushed the stock price up.

GM bonds, however, didn't budge. There were already worries in the bond markets that the company's debt might fall to "junk" status, and Kerkorian's attempt to buy up ownership in the company didn't change its financial situation one bit. And the very next day, Standard & Poor's did indeed drop GM's credit rating to "junk." The company's bond prices spiraled lower as investors worried that the company was headed toward defaulting on its debt.

Companies, of course, don't regularly default on their bonds, and GM certainly has not done so. But bond investors -- especially those who may not see their principals back for decades -- are particularly sensitive to the company's overall health.

"That makes it definitely worth watching how bonds are trading," said Lincoln Anderson, chief investment officer at LPL Financial Services. "When there are problems at a company, the institutional bond investors tend to figure it out before the rest of the retail market and dump their bonds."

A company's bond credit rating can be somewhat useful in determining a company's overall health, though not without caveats. Credit services like Standard & Poor's and Moody's assign credit ratings to corporate bonds, much like individual consumers have credit scores. S&P's rating system goes from AAA, the top rating, to D, which means the company is in default or has gone bankrupt.

Ratings of AAA, AA or A mean the company is in good shape and has the means to pay on its bonds for the foreseeable future. A rating of BBB, BB or B the company is in generally decent shape, but could be vulnerable to economic or market risks. CCC, CC or C ratings are considered junk bonds, meaning there is a substantial risk that the company may not be able to pay back the loan.

While bond ratings are a good indicator of a company's current health, they are less effective at predicting future performance.

"In their defense, the credit rating agencies can only analyze the information they have access to," said Michael Decker, senior vice president for research and public policy at the Bond Market Association. "It's a base to work off of."

Tracking a bond's price within a given rating can provide better insight. A CCC-rated bond that is trading higher means that investors think the risk that the rating brings is acceptable considering the interest payments the company will make on that bond. Another CCC-rated bond that has seen its price steadily deteriorate means the market feels the bond's higher yield isn't worth the price -- a tacit indictment of the company's health.

While information on corporate bonds isn't as widely available as stock prices, a number of sites offer bond prices and performance data, such as Yahoo Finance's Bond Center, which includes average yields for corporate bonds at the A-grade or better level. The Bond Market Association offers a site, www.investinginbonds.com, that has more detail on how the bond market works.