The common will cost you about 100% annual interest to borrow, assuming you can find any shares at all. Of course you won't need a $1:$1 hedge ratio, but it will be very expensive.
Distressed Debt Investing
- Thread starter FCXoptions
- Start date
Example from Seth Klarman:
Financial distress created such an opportunity in the debt and equity securities of the Bank of New England Corporation (BNE). A large loss announced in January 1990 caused the subordinated bonds of BNE to plunge to 10 to 13 from levels in the 70s. At the same time the common stock of the Bank of New England traded at approximately $3.50 per share.
Overall BNE had roughly $700 million face amount of senior and subordinated debentures outstanding with a total market value of less than $100 million. The common stock, which was, of course, junior to the holding company bonds, had a total market capitalization of approximately $250 million.
Opportunistic investors bought the BNE bonds and sold BNE common stock short to lock in an apparent valuation disparity. Specifically, investors could purchase the bonds at 10 to 13 and sell short common stock in equal dollar amounts. A buyer of $1 million face amount of subordinated bonds at 10 ½ (for $105,000) could sell short 30,000 shares of common stock at $3.50 for equivalent net proceeds. Performing these simultaneous transactions appeared to be a low-risk strategy under any conceivable scenario.
If BNE became insolvent (as happened in early 1991), for example, bondholders would at worst lose their investment and might possibly achieve some recovery; the common stock would certainly be rendered worthless. The loss on the bonds would at least be offset by the gain on the short sale of common stock. In addition, investors would earn interest on the short sale proceeds and might receive one or more interest payments from BNE (two semiannual coupons, as it turned out).
If BNE survived, the bonds seemed likely to rally by a greater percentage than the common stock. If the common stock triples to $10.50 amidst a surprising recovery for example, the bonds seemed likely to trade well above the 30 to 40 level that bondholders would need to breakeven. Again, investors would also benefit from interest payments received on the bonds as well as interest earned on the short credit balance.
Another possible scenario was a financial restructuring, whereby BNE would offer bondholders the opportunity to convert into equity. This alternative, which was seriously considered by the bank but ultimately proved to be unworkable, would have been highly favorable for those who were long bonds and short stock. The bonds would have benefited from the premium above market that the company would have had to offer to induce holders to exchange, while the common stock would likely have declined due to the dilution and selling pressure resulting from the issuance of large amounts of common stock to bondholders.
Financial distress created such an opportunity in the debt and equity securities of the Bank of New England Corporation (BNE). A large loss announced in January 1990 caused the subordinated bonds of BNE to plunge to 10 to 13 from levels in the 70s. At the same time the common stock of the Bank of New England traded at approximately $3.50 per share.
Overall BNE had roughly $700 million face amount of senior and subordinated debentures outstanding with a total market value of less than $100 million. The common stock, which was, of course, junior to the holding company bonds, had a total market capitalization of approximately $250 million.
Opportunistic investors bought the BNE bonds and sold BNE common stock short to lock in an apparent valuation disparity. Specifically, investors could purchase the bonds at 10 to 13 and sell short common stock in equal dollar amounts. A buyer of $1 million face amount of subordinated bonds at 10 ½ (for $105,000) could sell short 30,000 shares of common stock at $3.50 for equivalent net proceeds. Performing these simultaneous transactions appeared to be a low-risk strategy under any conceivable scenario.
If BNE became insolvent (as happened in early 1991), for example, bondholders would at worst lose their investment and might possibly achieve some recovery; the common stock would certainly be rendered worthless. The loss on the bonds would at least be offset by the gain on the short sale of common stock. In addition, investors would earn interest on the short sale proceeds and might receive one or more interest payments from BNE (two semiannual coupons, as it turned out).
If BNE survived, the bonds seemed likely to rally by a greater percentage than the common stock. If the common stock triples to $10.50 amidst a surprising recovery for example, the bonds seemed likely to trade well above the 30 to 40 level that bondholders would need to breakeven. Again, investors would also benefit from interest payments received on the bonds as well as interest earned on the short credit balance.
Another possible scenario was a financial restructuring, whereby BNE would offer bondholders the opportunity to convert into equity. This alternative, which was seriously considered by the bank but ultimately proved to be unworkable, would have been highly favorable for those who were long bonds and short stock. The bonds would have benefited from the premium above market that the company would have had to offer to induce holders to exchange, while the common stock would likely have declined due to the dilution and selling pressure resulting from the issuance of large amounts of common stock to bondholders.
It does have an option chain, and it doesn't look like their is a 100% implied put call parity disparity (hey it rhymes!) there so it might not be so expensive if you think the company will do something in the near term. I bought puts on them 9 months ago sure that there was no way they'd be around still and yet here they still are and my puts are virtually worthless, so take any advice I give on the subject with a grain of salt. I did look at the long bond plus put option back 9 months ago and it didn't pencil out, but things could have changed.
My idea was long for example $10,000 Sears bonds and short 10k stock. So you are hedged dollar for dollar.
Then you welcome bankrupcy. You hope you get a few intrest payments on the bonds before that (this will cover your short costs) So in the bankrupcy the stocks are worthless, but the assets will be divided among the bondholders. Of course the million dollar question is: how much this will be, but I am pretty sure that bondholders will be paid.
Or as is often the case if they strike a deal and submerge out of bankrupcy, the bondholders receive a combination of cash, equity and/or warrants in the new entity. This can be very lucrative if played correctly (not overpaying on the bonds to start with, as the bid ask spread is large)
Then you welcome bankrupcy. You hope you get a few intrest payments on the bonds before that (this will cover your short costs) So in the bankrupcy the stocks are worthless, but the assets will be divided among the bondholders. Of course the million dollar question is: how much this will be, but I am pretty sure that bondholders will be paid.
Or as is often the case if they strike a deal and submerge out of bankrupcy, the bondholders receive a combination of cash, equity and/or warrants in the new entity. This can be very lucrative if played correctly (not overpaying on the bonds to start with, as the bid ask spread is large)
It's not a bad idea, please let us know how it goes if you decide to pull the trigger. I feel like there are some unknown unknowns in there that I just haven't thought through enough, so I'd be interested in hearing the experience of a retail guy actually doing it.
aren't you risking having the bond proceeds tied up for a potentially long time as a work out/bankruptcy evolves ?
You can pretty much sell anytime, definitely takes a little bit from start to finish on the bankruptcy though. Part of the earlier returns depends on how good of a guess the market makes on what (if any) the actual recovery will be for each bond issue and pricing it at some form of discount to that. Sometimes you can get lucky and the bond will be trading pretty close to the anticipated recovery so you can just sell and lock it in vs riding it all the way out.
Thanks for posting the idea on here Chuck, I'm going to look into it as well.
I don't have any updates on here really other than the Gymboree bonds aren't doing so hot. Still in them and just going to ride that out for now. My VRX shares have done really well, didn't end up getting into their bonds, the equity play was where I saw the potential there.
Right now, I am about tapped out on funds as well as time so haven't made any new plays on bonds...took it to a different level on the distressed assets (not what I'd technically call it, more like distressed owners) and have bought a property in my area from a tax lien sale, possibly getting a foreclosure as well if their bank approves. Basically just riding on the second lien holder agreeing to take a big haircut. We will see!
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I think this strategy is tricky for a retail investor as the real alpha comes from the negotiations in bankruptcy court.
a little tricky being an understatement !
Yes, it's not doable without piggybacking off a big fund.