Monday, June 20, 2011

Distressed debt (et à Londres!)

This past week I have been looking into some investments in the area but they have been increasingly put on the back burner due to the news I alluded to last week.  There have been more positive developments on that front, I think, but things move slowly this time of year in Europe.  Everyone is on holiday and I am no different.

Tomorrow I am headed to London, mostly for pleasure but always partly for work (an investor always keeps his eyes open) for the week.  Afterwards I am going to Barcelona to meet up with a good friend and we are going to go skydiving.  I have never been before and so consequently my boots are starting to shake a bit.  Especially compounded by the fact that everyone tells me I'm crazy to do so!  Perhaps indicative of an existing pathology, I managed to approach skydiving from an investing perspective.  The risks are that I and the instructor will perish somewhere in the hills of northern Spain, and the rewards are a once in a lifetime experience that cannot be valued in terms of money.  I thought it seemed like a fair investment, what do you guys think?

So this article is again quite light in terms of information.  But I like to teach through experience instead of lecture, and am drawing a blank on what stories to tell.

I suppose I could talk a bit about the distressed bonds I purchased from CIT Group prior to their bankruptcy restructuring.  I've talked a little about distressed equity in the past but it makes sense to discuss bonds, since no portfolio should be without them ideally.  Distressed bond investing, however, is not for the faint of heart, and requires a keen understanding of security analysis as well.  Unlike their higher rated counterparts, bonds under duress need to be monitored carefully.  But what does this entail?

Well, first off, you need to understand the company's capital structure.  So in the example of CIT, I looked at the comparison of how much bond debt they had vs. what sort of assets they have.  From these assets one needs to remove things like trade debt (accounts payable, etc) and bank loans if they have a higher priority than the bonds.  In fact, by looking through information on the class of bond you are buying you can find out in what order these bonds like in terms of claiming power.  Remove all of the classes above these bonds from the assets of the firm to see what is left afterwards.

Keep in mind the bond will only ever pay out at 100.  Yet most distressed bonds will trade at a healthy discount to this-- CIT Group 2010 bonds were trading at around 62 I believe when I first started buying them.  The beauty of the CIT Group transaction was that the company itself had significant assets at the time, but faced a serious cash problem that was impossible to remedy before the 2010 bond maturity.  The market knew this and adjusted the price accordingly, but like the market always does, it overreacted.  So I was a buyer.

And then we CIT Group bondholders got a delightful message.

This is the wrench that gets thrown into security analysis.  Because as much as you can pour over company reports and come to conclusions about the value of things, companies are run by people and people are unpredictable.  CIT Group wanted the bondholders to take a haircut and restructure in a very unfavorable way to investors.  It never ceases to amaze me what companies will try on with their investors from time to time.  The first proposal went to vote, and I voted against it-- as did the other bondholders, and the company became insolvent and could not repay its debt.  It declared bankruptcy shortly afterwards.

Now, who wants to hold stake in a bankrupt company?  Well, not I, normally, and certainly not the common equity.  Remember that the common equity is the last in line to receive anything in the case of a restructuring.  I had a professor that said the order of priority in a corporate restructuring is: Trade debt, secured senior loans and senior bonds, unsecured mezzanine loans and bonds, preferred stock, dog shit, then common stock. If you are holding common stock during a bankruptcy you are probably in serious trouble.

But at the higher tiers, you may be entitled to actually benefit from a bankruptcy restructuring.  This was the case in the CIT Group Distressed bonds.  There was a restructuring, not a liquidation, eventually, and I ended up a bigger piece of the pie than the money I put in.  While I wasn't 100% sure that this would happen, I did have a good idea because I knew the scope of CIT Group's operations and what sort of normal EBIT they were likely to have.  So long as they could maintain a healthy EBIT over interest margin, these were bonds that I wanted to have because the price was so right.  And it was non-normal market conditions that were brutalizing this provider of corporate loans.  It was a good time to deploy cash, because cash was so rare.  Cash fetches you the best price where it is most desired.  Like anything else.

Hope that I don't die next weekend so I can continue to entertain and possibly enlighten.

Think positive this week and what you desire most will come to you.


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