Pair Trading the Only Reliable Way

[A.J. Sutton]

The concept is to play the seniority of the securities. It works when a company is under stress, as in at risk of bankruptcy, but when you see it has some assets and a valid business. Not good if it is a flake company that is worth zero. But if the thing is worth something, just over-leveraged, then, the smart money being in the bonds, they will exit earlier, pushing prices down. Or, they are not smart money but are forced out of the bonds due to ratings downgrades, your friends. Meanwhile, the sheeple are in the common, which may be crashing, but it still overpriced. So you buy the debt and short the common. Balance it the way you happen to feel, but for me, I would overweight the debt 4 to 1 or something like that. Your risk is that the company does a good recovery. Your gain is if the company goes bankrupt, in which case, depending on the seniority of the debt you bought, will make money as the common will go toward zero. Or do it after bankruptcy, when both the debt and common will trade down hard. Of course, when the common gets near a buck, it will have some support from the lottery players. Therefore the pair trade has to be made when the common is significantly above $5, better higher.

I have done this for years, when I was not just playing the debt for gains. For safety, you hedge with the common short. With true conviction on the debt, should it be cheap enough, you just load up on that.

 

[gkishot]

The concept is to play the seniority of the securities. It works when a company is under stress, as in at risk of bankruptcy, but when you see it has some assets and a valid business. Not good if it is a flake company that is worth zero. But if the thing is worth something, just over-leveraged, then, the smart money being in the bonds, they will exit earlier, pushing prices down. Or, they are not smart money but are forced out of the bonds due to ratings downgrades, your friends. Meanwhile, the sheeple are in the common, which may be crashing, but it still overpriced. So you buy the debt and short the common. Balance it the way you happen to feel, but for me, I would overweight the debt 4 to 1 or something like that. Your risk is that the company does a good recovery. Your gain is if the company goes bankrupt, in which case, depending on the seniority of the debt you bought, will make money as the common will go toward zero. Or do it after bankruptcy, when both the debt and common will trade down hard. Of course, when the common gets near a buck, it will have some support from the lottery players. Therefore the pair trade has to be made when the common is significantly above $5, better higher.

I have done this for years, when I was not just playing the debt for gains. For safety, you hedge with the common short. With true conviction on the debt, should it be cheap enough, you just load up on that.

What happens if the company improves & the common recovers?

 

[A.J. Sutton]

If you bought your debt cheaply then if the company recovers it would presumably go to par. I generally will do these pair trades when the debt trades to around 30% of face, and the company has serious problems. At that point the common would be under $10 usually. But of course if the company recovers and flies high, you lose. But in that case, as in everything else, if the position goes against you, close out at least one leg of it, as in cover the short and keep the bonds.

 

[gkishot]

If you bought your debt cheaply then if the company recovers it would presumably go to par. I generally will do these pair trades when the debt trades to around 30% of face, and the company has serious problems. At that point the common would be under $10 usually. But of course if the company recovers and flies high, you lose. But in that case, as in everything else, if the position goes against you, close out at least one leg of it, as in cover the short and keep the bonds.

What is the average holding period of the pair?
What is the average annual return of this strategy?
What is a systematic way to screen for such companies?

 

[A.J. Sutton]

Holding period depends on the cost to borrow for the short. With companies at risk of bankruptcy, this can be high. So you need a catalyst, for example bond maturities that will force a bankruptcy unless something is done- like a prepack.

Annual return will vary, as usual, but will be less, but safer than a naked position, long or short, in either the stock of the bonds. After all, it is a hedge, of a securities seniority arbitrage.

One way to find the companies is to look at bankruptcies by following an industry that is getting chewed up- oil and gas right now. A systematic way would be to look at stocks with new lows, then look at their bonds and see if they are selling to yield, say, at least 25% to maturity. This kind of yield doesn't happen unless the companies are distressed.

I should also mention that the common tends to be way overvalued in these cases. Bondholders are the smart money and therefore bonds sell off sooner. Low-priced stocks become lottery tickets and there are plenty of stupid money that goes into lotteries.

 

[newwurldmn]

This is a common hedgefund strategy: capital structure arbitrage.

Another way to trade it is to buy DOTM puts (effectively bankruptcy puts). Fixed loss and fixed gain if company doesn't go under. Fixed gain on option and unclear loss if company does go under.

 

[gkishot]

Holding period depends on the cost to borrow for the short. With companies at risk of bankruptcy, this can be high. So you need a catalyst, for example bond maturities that will force a bankruptcy unless something is done- like a prepack.

Annual return will vary, as usual, but will be less, but safer than a naked position, long or short, in either the stock of the bonds. After all, it is a hedge, of a securities seniority arbitrage.

One way to find the companies is to look at bankruptcies by following an industry that is getting chewed up- oil and gas right now. A systematic way would be to look at stocks with new lows, then look at their bonds and see if they are selling to yield, say, at least 25% to maturity. This kind of yield doesn't happen unless the companies are distressed.

I should also mention that the common tends to be way overvalued in these cases. Bondholders are the smart money and therefore bonds sell off sooner. Low-priced stocks become lottery tickets and there are plenty of stupid money that goes into lotteries.

Thank you for taking your time to answer my questions.
As for the oil & gas companies, they seem to be in a recovery mode right now. So I am not sure if your strategy is making you profits in this particular case. Wouldn't be a simpler strategy just to hold distressed bonds until maturity or when the yield to maturity indicates a recovery?

 

[A.J. Sutton]

Yes, the crisis seems to have passed for now, but we will see if companies can make money in this environment. One example is CHK, whose stock and bonds have both come back, and yet it is still losing large amounts of money and only survives by selling its better assets. It seems as if in this case the market is wrong on its prospects, but we shall see.

 

[gkishot]

Yes, the crisis seems to have passed for now, but we will see if companies can make money in this environment. One example is CHK, whose stock and bonds have both come back, and yet it is still losing large amounts of money and only survives by selling its better assets. It seems as if in this case the market is wrong on its prospects, but we shall see.

I understand your strategy is essentially a bet that the company will eventually go bankrupt. I believe the better way to make money is to bet that the company already has hit the bottom and it will spring back to life. And possibly being paid while waiting.

 

[A.J. Sutton]

Bankruptcy is not the end, except for the common stock. Many times I have bought the debt by after bankruptcy anticipating that the new common in the recapitalized company will have some good value. The one key requirement there is that the business the company in is decent, so that the bankruptcy was simply a problem of too much leverage, too much debt.

But for those companies that will survive but are on the edge, I would still go with the debt over the common, even if you don't hedge by shorting the common. That can work out very well if the company survives, but if it goes bankrupt, you won't be wiped out, and may well come out ahead in the reorganization.