Sometimes equity investors have a habit of overlooking the bond/credit markets. But in times like these, when credit markets are tight, the states of corporate balance sheets become more important than ever and it becomes imperative for all equity investors to watch and understand the credit markets.
Take Suncor Energy (TSE: SU) for example. SU was Canada’s favourite oil and gas stock from 2004 – 2007. It is one of Canada’s largest oil and gas stock (by market cap), it produces almost 300,000 Boe/d, earns over $2 billion per year, and has probably the most ambitious plans for the Albert Oil Sands – plans that were originally estimated to cost ~$6 billion.
Now that oil prices have tumbled by over 70%, oil and gas companies like SU are cutting production and reducing budgets for major projects. In the case of SU, management has recently slashed the budget and scale for its new Oil Sands project by roughly half. The equity market responded accordingly and SU’s stock price fell by almost 70% from its peak.
Still, many investors look at a company like SU and suggest that it’s now trading at deep value territory and may be a good long term investment. Those investors could very well be correct; given that SU’s stock price has recently held within a well defined trading range, the stock could be showing signs of bottoming. However, now may be a good time to see what the credit market thinks of SU’s future.
A good place to start would be to check out the price of a credit default swap on SU’s debt. But, before we begin, we’ll start with a quick primer on credit default swaps.
A Primer on Credit Default Swaps (CDS)
Credit default swaps are agreements between two parties that are essentially a form of insurance against default on an underlying credit instrument. A CDS may for example reference a 5 year bond of a particular company. You or I could buy that bond and receive the coupon (interest) payments until maturity, at which point we receive our principal back. The risk we, as the purchaser of the bond, are exposed to is the chance the company may default on repaying the bond. A CDS is a way to protect against this risk. The purchaser of the CDS pays a periodic fee (commonly referred to as the CDS price) for credit protection. The seller receives the periodic payment in exchange for a commitment to guarantee the principal re-payment of the bond.
