On many occasions, I’ve discussed the large debt loads carried by major gambling operators, and the effect that debt can have on their stocks. Caesars Entertainment (CZR) has a market capitalization of $2.6 billion; but its total debt nears $20 billion. MGM Resorts International (MGM) stock is worth a total of $4.5 billion; but the company owes nearly three times that much, at $13.4 billion as of March 31st. Smaller US operator Isle of Capri (ISLE) is worth just $230 million; but its outstanding debt totals $1.2 billion.
For shareholders, large debt loads can be problematic, to say the least. As I noted in March when recommending a short position in ISLE, the cost of interest on the debt can eat up a company’s profits – the very profits that should be going to shareholders. High levels of debt limit a company’s ability to make acquisitions, invest in the business, or enter new markets. Of course, high debt can also cause bankruptcy, if a company becomes unable to pay back money it has borrowed, leaving shareholders with nothing. Just ask the gambling world’s most famous mogul, Donald Trump, who has seen his Atlantic City operations go broke four different times.
For stock investors, particularly in the gambling sector, debt can truly be a four-letter word. But investors can also purchase that debt directly, through corporate bonds. Bonds sold by Caesars, MGM, and Isle of Capri – not to mention industry heavyweights such as Las Vegas Sands (LVS), Wynn Resorts (WYNN), or International Game Technology (IGT) – are available for purchase by investors on the secondary market.
The pricing of a bond is expressed as a percentage of its “par value” – the price at which the bond is issued. For most corporate bonds, par is $1,000. A bond priced at 80 with a par of $1,000 would sell for $800; a bond priced at 120 with a par of $1,000 would sell for $1,200. Most bonds are issued for a fixed duration – perhaps 5 years – at a fixed interest rate; say, 7 percent per year. Thus, a $1,000 MGM 7% bond that matures in 2017 would offer $70 in annual interest payments for each of the next five years, with the original $1,000 in principal returned to the investor in 2017.
But if the bond is purchased in the secondary market, its return characteristics change markedly. If the aforementioned MGM bond is priced at 80, the investor is paying $800 for the bond, instead of $1,000; but he still receives $70 in annual interest payments based on the $1,000 par value. As such, his interest received relative to his investment – known as the current yield – is no longer 7 percent, but 8.75 percent, as he is receiving $70 per year on $800 invested. If the bond is priced at 120, the current yield drops below the interest rate; he is receiving $70 per year on $1200 invested, for a current yield of 5.83 percent.
Of course, current yield misses a key factor: the fact that par remains at $1,000. If the bond is bought at $800, in five years, the investor will receive not $800 – but the $1,000 par value. Conversely, if the bond is bought at $1200, the principal returned at maturity will still be only $1,000. The annual return received if an investor holds the bond until it is repaid is known as the “yield-to-maturity.” (You can find a yield-to-maturity calculator here.) At 80, our hypothetical MGM bond has a yield-to-maturity of 12.64%, a handsome return. At 120, the yield-to-maturity plummets to just 2.67%, as much the gain in the $70 annual interest payments is lost by the $200 principal loss assumed by buying the bond well above its $1,000 par. Lower bond prices imply higher yields, and vice versa.
What moves bond prices? Everything. In the case of our hypothetical MGM bond, the condition of MGM itself can be a huge factor. If MGM issues additional debt, or shows weaker-than-expected earnings that portend less future cash to pay back bondholders, the price of a bond will drop. Investors will demand a higher effective interest to compensate for the single greatest risk for a bondholder: the risk that a company will not be able to pay back the money it has borrowed. In this case, our MGM bond trades at 80, as investors demand the yield-to-maturity over 12% to compensate for the risk that MGM may default on the bond. Conversely, if MGM performs well, and it becomes apparent that the company will easily have enough cash to pay back both interest and principal to its bondholders, the price of its bonds will rise, as investors demand a lower return to assume the debt obligation. Much like in stocks, the success – or failures – of a company translate directly to its bond price.
Myriad other factors influence corporate bonds as well, notably the interest rates offered by US Treasury bonds. A key valuation figure for corporate bonds is the “spread,” or the difference in return between the bond and a so-called “risk-free” asset, usually a form of US government debt with the same maturity (despite the fact that the events of the last five years have called into question the US government’s “risk-free” designation.) Right now, a 10-year US government bond offers annual yield of 0.67%. The spread is simply the difference between a bond’s yield and the “risk-free” asset, measured in hundredths of a percentage point. At par, our hypothetical 7% MGM bond is trading at a spread of 633 basis points, or 6.33%, in relation to US Treasuries. This spread accounts for the risk investors are taking in lending to an economically sensitive casino operator, as opposed to the government of the world’s most powerful nation. If MGM does well, the spread should narrow; if it struggles, the spread will widen.
The problem for individual investors is that the above explanation of the bond market is, practically speaking, pretty much worthless. Recommending direct investment in the bond market based on those principles is roughly akin to teaching someone hand strength and calling odds in poker and then suggesting they take their life savings to Las Vegas. Like in poker, the basics seem simple; but the practical math involved can be mind-bogglingly complex. And, like a poker room, the bond market is a ruthless, calculating place where “sharks” attempt to take “fish” for every dollar they can. Indeed, despite the vast transformation of investing by technology, the bond market is stubbornly opaque; most bonds are still traded “over-the-counter,” with prices directly and discreetly negotiated between buyer and seller, with commissions often higher than in the equity markets (particularly for poorly connected individual investors). Many corporate bonds trade with esoteric features such as call and put options (where the issuer, or the borrower, can mandate redemption of the debt ahead of its schedule) or convertibility into shares of company stock, which make simple yield calculations irrelevant. The vast numbers of issuers, maturities, and features of bonds – whether they are corporate, sovereign, or municipal – make the bond market a very difficult place for the individual investor. This is why, despite its popular connection to the stock market, Wall Street’s bond, or fixed-income, departments dwarf their equity counterparts in prestige, profits, and salaries. And it is why nearly all investors with bond portfolios use managed funds for their investments, as opposed to individually selected bonds.
Still for investors in the gambling sector, a basic understanding of bonds is key, if only because the gambling industry is literally fueled by debt. Corporate bonds create the capital for MGM’s $8 billion CityCenter property in Las Vegas and Sheldon Adelson’s proposed $35 billion “EuroVegas”. The gambling sector is one of the most leveraged industries in the world, and the volatile nature of the business means that interest costs are higher than in other businesses and can affect stock returns. For instance, Isle of Capri last month issued $350 million worth of debt at 8.875 percent interest. The proceeds from that offering will be used to pay down debt maturing in 2014, with an interest rate of just 7 percent. The increase in interest represents about $6.5 million a year, a not-insignificant amount given that Isle of Capri generated about $43 million free cash flow for shareholders in 2012. For companies such as Caesars and MGM, who may need to refinance debt over the next few years, higher interest rates can lead to higher interest expense – and lower earnings.
In addition, bond prices – and bond ratings – can offer key information about the financial health of companies in the sector. The three major agencies – Moody’s, Standard & Poor’s, and Fitch Ratings – rate bond issuers from AAA (the strongest) to C (the weakest), with Moody’s using a slightly different scale on the steps in between. The agencies are hardly perfect – their egregious AAA ratings of mortgage-backed securities during last decade’s housing boom has been widely publicized – but their opinions still carry significant weight in the fixed-income community, and remain a solid indicator of a company’s financial strength. For instance, in the gambling sector, where the business’ inherent volatility and reliance on discretionary income creates constant credit risk, nearly all bonds issued by casino operators are rated as high-yield, or “junk” bonds.
“Junk” is not quite as insulting as it sounds; it simply refers to bonds rated lower than BBB- by S&P or Fitch, or Baa3 by Moody’s. Essentially, a “junk” rating on a bond simply means that the bond is not “investment grade” because some level of default risk exists. That default risk is the key bit of information equity investors can glean from bond prices: how likely is the worst-case scenario?
Overall, the bond market seems relatively complacent about the future of the gambling industry. (Interested readers can view bond prices through the Financial Industry Regulatory Agency (FINRA) website here.)Yields on longer-term bonds from leaders Wynn and Las Vegas Sands sit between 4.5 and 5 percent, with their ratings at the top of the “junk” scale. Companies like MGM and Isle of Capri, they of the larger debt balance and more precarious financial position, see their longer-term debt in the 6-8 percent range, with most of their debt rated B-. That’s toward the lower end of the ratings scale, in the “highly speculative” range, but still acceptable in the traditionally volatile gambling industry. Both the ratings on and the yields offered by MGM and ISLE debt show that the bond market expects both companies to at least cover their debts, while having some awareness that a major event – such as a protracted double-dip recession in the US or a catastrophe at one of the companies’ properties – could lead to severe repayment issues, even if such an event remains relatively unlikely.
Two gambling companies jump out when looking at spreads and yields in the sector. The first is Boyd Gaming (BYD). Like Isle of Capri, Boyd has an extensive debt load – over $3 billion in debt in comparison to a market value of about half a billion dollars. Like Isle of Capri, Boyd’s interest expense eats up all of the cash that should be earmarked for shareholders – and then some. But, compared even to Isle of Capri, the bond market is extremely pessimistic on Boyd. Yields on Boyd’s 2016 and 2018 debt exceed eight percent, with the 2016 debt rated by Fitch as CC, the second-lowest rating available for a bond not yet in default. With Boyd stock crashing 18% after weak second quarter results last month, it appears pessimism is surrounding Boyd Gaming from all sides.
The most notable gambling company in the bond market, however, is Caesars Entertainment. Caesars is the largest borrower in the entire gambling sector, with some $20 billion in debt. (By comparison, Las Vegas Sands, whose market value is about 12 times higher, owes just $9 billion.) Caesars’ debt was largely accumulated during a 2008 leveraged buyout – in which a company issues debt to buy out its shareholders and take itself private – agreed to at the top of the stock market bull run in 2007. It attempted to reverse that mistake and cut its private owners’ losses earlier this year with a blatantly manipulated public offering that CNBC’s Gary Kaminsky called ) “the dumbest thing I’ve ever seen.”
But it’s not just the size of Caesars debt that makes it notable. According to FINRA data (available under symbol HET; the debt was issued under Caesars’ former name, Harrah’s Entertainment), five different Caesars bond issues, maturing between 2016 and 2018 are trading at yield-to-maturity over 19.5 percent. Nineteen point-five percent. The spread between the issue maturing 2017 and the five-year US Treasury is over 2,100 basis points. To be fair, part of the reason for the spread is that Caesars has sold secured debt (debt backed by specific company assets), meaning unsecured Caesars creditors would be at the back of the line in the case of a default. Indeed, those creditors could be, like equity shareholders, left with nothing if Caesars does default. (Secured debt issued in 2009 and again earlier this year does trade at far lower yields, closer to that of other leveraged casino companies.)
But still, a 2,000 basis point spread is incredibly wide, and its existence tells equity investors that the bond market believes that there is a realistic, even significant chance that Caesars will default on its debt obligations at some point in the next five years. Bond investors will lend without collateral to the US government at around one percent; they will lend to IBM below 3 percent; they will lend to Las Vegas Sands at around five percent. For an unsecured loan to Caesars? As much as 24.6 percent interest annually – more than most credit cards. Why? Because the bond market is worried not only that Caesars could default, but that the company would not have enough assets for its creditors to get at least part of their principal back through a restructuring (where creditors exchange debt for new debt or equity) or a liquidation (wherein Caesars’ assets would be sold and the cash returned to bondholders). In that scenario, Caesars stockholders would be almost certainly be completely wiped out.
This should be an important red flag to investors considering an investment in Caesars stock. The “smart money” – bond investors whose careers literally depend on understanding which companies will survive and which will not – is skeptical of Caesars, at best. Equity investors should be, too.