Quantcast
Channel: Daily Bankrupt Company Updates | Bankrupt Company News
Viewing all articles
Browse latest Browse all 4593

When to Buy Bonds Instead of Stock

0
0

A couple of times in recent months I’ve suggested that the bonds of one of my recommended companies might have become more attractive than the stock. Because of this and because ongoing turmoil in the distressed debt market is driving more bonds down to interesting levels, I thought it might be helpful to discuss why you might want to buy bonds rather than stock under certain circumstances.

As with any investment decision, the key to deciding where to invest in a company’s capital structure is evaluating risk and potential reward of a particular investment. Obviously you want to minimize the risk and maximize the reward. Unfortunately, one of the fundamental rules of investing is that bigger rewards (higher returns) almost always come with higher risks, and vice versa. Therefore, you have to understand how much risk you are willing to take on in order to achieve your return objectives.

The level of risk in a particular security is ultimately governed by a bankruptcy rule called the “rule of absolute priority.” Why should you even think about bankruptcy? Because that is the ultimate downside risk with any investment. If a company fails, it will end up in bankruptcy, and there is not likely to be enough value left in the company to pay off all of its creditors and stockholders.

The rule of absolute priority says that in bankruptcy stakeholders must be paid off in the order of the priority of their claims. Higher priority claimants (such as the holders of secured debt) must be paid off in full before holders of lower priority claims (such as unsecured bondholders and stockholders) receive anything. Unfortunately, stockholders come at the very end of the line, so that all other creditors must be paid off in full before the stock gets anything.

When a company is healthy, its bonds usually trade near face value, which is the amount the bondholders will receive when the bond matures. Bond prices are usually quoted as a percent of face value, with 100 being the full face amount. Therefore, a bond that trades close to 100 is considered to have very little risk of defaulting. That is obviously good news for the holder of the bond, but the bad news is that the only return the holder will get is the interest from the bond, which is usually quite low.

When a company is having trouble, however, bondholders begin to worry that maybe they won’t get paid off when the bond matures. As nervous bondholders begin to sell, that pushes the price down because the purchasers demand a higher return to justify the increasing risk of holding the bond. For example, if the price of a bond drops to 50 a buyer would be able to double his money if the company recovered and was able to pay off the bond at 100 at maturity—plus the buyer would collect the interest along the way.

If the company continues to have trouble and realizes that it will not be able to pay off its bond in full, it will attempt to restructure the debt by getting the holders to agree to be paid off at less than the face amount of 100. The bondholders may agree to this voluntarily, or they may be forced to accept less than 100 through a bankruptcy case.

All of this detail is a lot of background information but important to understand when deciding how to invest in a troubled company. Now let me turn to a specific example: Freeport-McMoran (FCX). When my distressed investing newsletter first recommended this stock pick 2 ½ years ago, I (and most other investors) did not realize how low natural resources prices would fall. The stock was then trading at 28, down from 60 a few years earlier, and the company’s bonds were close to 100. Fast forward to today with the prices of copper and oil (Freeport’s main products) at much lower prices—and investors are questioning whether Freeport will be able to survive if the prices of its products stay this low for a protracted period. The stock is down to 7 and change, and some of the company’s bonds are trading in the 50s.

If natural resource prices rebound, the stock could go back to 28 or even 60, which would be a spectacular return. The risks are pretty big, too: If Freeport is forced into bankruptcy, the stock will be essentially worthless. If you bought the bonds today instead of the stock you could still almost double your money if natural resource prices improve again, and your risk would be quite a bit lower. While there is a small chance that the bonds could be worth close to zero in a bankruptcy, they are much more likely to get at least some recovery than the stock. Going back to the rule of absolute priority, there are even scenarios where your bonds could get paid off at close to 100 in a bankruptcy even though the stockholders receive almost nothing.

Unfortunately, it is difficult to quantify the risk in the stock versus the risk in the bonds with any precision. Every investor needs to evaluate how much downside he can stomach. If you are willing to take the risk of the stock possibly going to zero, the gain potential in a stock like Freeport looks pretty attractive. If you are willing to take on some risk for the opportunity to double your money, maybe the bonds are the best place for you to invest. If you are unwilling to take any risk that you could lose your whole investment, you probably shouldn’t invest in either the Freeport stock or bonds right now. Incidentally, I continue like the upside potential in the stock pick, so I am keeping it as a buy recommendation; however, it is now only appropriate for investors with a high tolerance for risk.

For investors who are comfortable selling stock “short,” there is another investment opportunity in these types of troubled companies. Selling short means borrowing stock and selling it in the hope that it goes down; you then buy the stock back at the lower price and return it to the lender, pocketing the difference between the price where you sold the stock and the price where you bought it back. If the stock goes up, however, you lose because you have to cough up more to buy it back than you received by selling short.

You could put on a hedged position by buying the bonds and selling the stock short. That way you are protected if the bonds end up worthless too because your profit on the short sale of the stock will offset your loss on the bonds. There are also scenarios where you make money on both sides of the trade because the bonds go up and the stock goes down. Of course, if the company fully recovers you could lose more on your short when the stock rebounds sharply than you make from your bonds. This is an interesting—and frequently profitable—strategy, but it is only suitable for very experienced investors. The most recent issue of The Turnaround Letter details five additional distressed investing opportunities where both the bonds and the stock have good upside potential as well as substantial downside risk.

Disclosure Note: Accounts managed by an affiliate of the Publisher have positions in Freeport-McMoran.

The post When to Buy Bonds Instead of Stock appeared first on Daily Bankrupt Company Updates | Bankrupt Company News.


Viewing all articles
Browse latest Browse all 4593

Latest Images

Trending Articles





Latest Images