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How do you select between the stock and its bonds?


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Quite often, the stock of a company trading at a depressed level will also have its bonds trade well below par. Taken to the extreme, it would indicate that there is no value left in the common shares when the bonds are trading at 50 cents or below on the dollar due to their higher ranking in the capital structure. 

 

Sometimes, it is truly the case and the selection is obvious: buy the bonds and forget about the stock. Sometimes, it looks like that the bonds have as much upside as the surviving stock and once again the selection is easy.

 

However, it is not always that clear cut and there are instances where the bonds trade well below par with the stock looking like a promising investment with a higher return potential. How do you select between the two in these instances? What is your thought process?

 

The question also applies to convertibles and preferreds.

 

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If you're really sure company won't go BK (and won't dilute you to heck), buy stock.

 

Otherwise, buy bonds or not invest at all.

 

This year so far the right decision has been not to invest at all.  :-X

 

Of course, you can also make some kind of probability based spreadsheet calcs. 10% stock goes 10x, 90% it goes to 0. vs. bonds 25% goes to par, 40% goes to $.25 work out, 35% goes to 0. Probability guessing is hard though.

 

 

Speaking about energy, in 2008-2009 the right decision was to buy stocks, since pretty much no company went BK. This year, it was to buy bonds or nothing. Distinguishing the two - V recovery vs. U or L - is hard. That's why a lot of people think commodity company investing is lost cause. :)

 

Good luck. It is getting painful out there.

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Focus on the business, payback period, & dilution risk; not the BK risk. And keep in mind the typical institutional IP constraints when the instrument is close to a break-point. An over leveraged good business, can easily be fixed through either a debt/equity swap, or asset sales; a bad business, not so much.

 

These FI investments are long term (5-10yr) workouts, with a sweet-spot around 45-50c on the dollar. A 16% cash yield will usually repay the outlay < 3 yrs, and leave 2-6 years of future potential recovery. By itself this is still a risky proposition; bundle it with an equal investment in a treasury yielding 1% - & you get a more respectable risk reducing barbell producing around an 8.5% cash yield, comparable to a pfd. But in this game - the preference is bonds, as there can be no restructuring without a sweetener going to bondholders.

 

There is a similar game in blue chip equities, right after deep dividend cuts have been announced.

 

It has worked very well for us. FTP, TA, PDS being some of our better examples.

 

SD

 

 

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It's not a question you can give a blanket answer to because every situation is different, but let's say you can lump these situations into two categories: (1) situations where the bonds are still trading on a yield basis, and an outcome in which the bond is paid until maturity is still likely, and (2) situations where bonds are trading on a recovery basis, and it's highly unlikely they survive to be paid out as scheduled.

 

In (1), it is about choosing an appropriate risk-reward within the capital structure, and comparing your perceived risk of the assets versus the expected returns on the stock and the debt. I don't think there is much of a blanket statement to make here other than you obviously take higher risk with the equity position and expect to be rewarded with a higher expected return, and you need to be comparing the yield of the bonds to whatever you think a reasonable return on the stock is. How big of a spread there should be obviously will depend on the business itself and how volatile you expect its value to be, how much debt there is versus equity, where the particular tranche of debt you are evaluating is sitting within the capital structure and how much security there is in how the agreement / other agreements are structured, etc.

 

In (2), unless you believe the market has it completely wrong, if you are seeing things trade in the 50s or below, most likely the debt is no longer trading on a yield basis where someone is thinking about the spread they need to be rewarded in order to buy the paper [with exceptions, clearly a very high duration bond i.e. a newly issued 30 yr treasury could trade at 50 just based on yield]. Instead, it's trading on where people think recovery value is in a restructuring, whether in court or out of court. In these situations, the equity is also no longer a security that is trading based on expected required returns - it's an out of the money option on the value of the business.

 

Playing with buying the equity in this case is usually a foolish game; it's highly likely the equity is a zero or near zero. Investing in distressed debt can be rewarding but is really best suited for specialists and people who can actually get involved in the process, not retail investors. So I would simply avoid this type of situation from the perspective of someone at home.

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