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What is the optimal mix of equity and debt that an investor should invest in a single company?

If an investor invests in both the debt and equity of a company, they are in effect de-levering the company (or reversing part of the capital structure decision of the company).

Asset allocators, such as pension funds, tend to invest in both the equity and debt of companies as determined by their weighting in their benchmark indices. This seems like a rather arbitrary method of investing based on the amount of issuance. At worst it may be counterintuitive in that higher debt issuance (potentially more leveraged company) would have bond investors buying more of that company's debt.

How should an investor quantitatively decide on the optimal mix of debt and equity for their portfolio? Should an investor ever invest in both the debt and equity in the same company if the management of the company is in the best position to determine the optimal capital structure?

How should the optimal proportion of debt for high yield debt issuers and investment grade issuers be treated differently given that debt can be looked at as a default free bond and a short put option on the issuers equity?

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I answer from the point of view of a small price-taker investor.

Investing in debt and equity depends on very different analysis. If on one side you have the ability and willingness to repay depending on the credit quality of an issuer, on the other you have the ability of generating consistent cashflows with a well managed liquidity and long-term growth. Therefore, my answer is yes, it makes sense to invest in both debt and equity of a company. This answer must be mitigated by two points:

  1. some factors impact both debt and equity investments (see Leverage)

  2. Assuming the perspective of a balanced investor (i.e. one who invests in both asset classes) it makes sense to understand the market conditions. In fact, debt and equity carry different return/risk profiles. In good moments, makes sense tilting towards the more aggressive equity and the converse. Indeed, Markowitz asset allocation idea was based exactly on the tradeoff Expected Returns and Volatility, where Expected Return is conditioned upon the good/bad market expectations. Starting from this stronghold, there are many other ways for deciding the optimal mix. For instance, one may look at Risk-Parity allocation, where the mix tries to reflect an equal risk exposure to both debt and equity.

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  • $\begingroup$ Thanks @VitoC for your response. So how would you determine proportion or weights of equity and debt within the same company? $\endgroup$ – AlRacoon Jun 5 at 12:21
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You can use the company specific yield gap( dividend yield / company's long term debt yield) as an indicator to switch between debt and equity. Larger yield gap indicates equity is cheaper compared to debt.Tons of such indicators are available which compare the relative valuation of debt and equity. You can overlay it with momentum also.

Someone suggested risk parity but it is highly concentrated in bonds only unless you take leverage.

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  • $\begingroup$ Thanks @Dhruv Mahajan for your response. So how would you handle stocks that do not pay a dividend? Also your answer seems to imply one would only invest in the equity or debt, not both (switching between the 2 based on your signal). $\endgroup$ – AlRacoon Jun 5 at 12:23
  • $\begingroup$ You can use other signals for non-dividend paying stocks, one common replacement is free cash flow yield instead of dividend yield but again you'll have to research this because it's a very vast topic. And no I'm not saying completely switch out, you're going to deviate from your base allocations. For example, if you're willing to take risks your base allocation would be 70% equity and 30% bonds, if the yield gap is high, you'll change it to 90-10, otherwise it'll be 50-50. Or if you're risk averse you'll choose a base allocation of 40 equity and 60 bonds, many permutations are possible. $\endgroup$ – Dhruv Mahajan Jun 5 at 16:08
  • $\begingroup$ All depends on your level of risk averseness $\endgroup$ – Dhruv Mahajan Jun 5 at 16:08
  • $\begingroup$ Yes it is a very vast topic. I'm trying to see if anybody has developed a framework/methodology to allocate between these securities that takes into account the capital structure of the firm as well as the investor's risk appetite. $\endgroup$ – AlRacoon Jun 6 at 16:29

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