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The Turnaround Letter has launched a new series on investing in distressed securities. In this second note, we focus on distressed bonds and explore some reasons why their returns can be so high.
First, a brief primer on some bond terms we use. We typically refer to a bond’s price as a percentage of its face value. If the bond is priced at 100, then it is priced at 100% of its face value. If the price is 80, you are paying 80% of its face value. The price will drop when the chances of receiving the full face value at maturity declines. This price drop increases your potential return: if you pay 80 for your bond and it goes to 100, your return is 25% (excluding any coupons), but if you pay 60 for your bond and it goes to 100, your return is 67%.
Capital markets, for the most part, are efficient at setting the price for mainstream bonds. That is, the bond’s price accurately reflects all the information that is publicly available. Market efficiency is greatly enhanced when the range of likely outcomes is narrow.
You can be fairly confident, for example, that Procter & Gamble’s 3.1% notes due 2023 are correctly priced at 101. With P&G’s strong and stable operating profits and its relatively low debt burden, the range of possible outcomes is narrow – it’s very likely that you will receive all of your coupons on time and full face value in August 2023 when the bond matures.
However, as the profit stream drifts away from predictability, the range of possible outcomes expands and bonds become more inefficiently priced. If profits are highly cyclical, products/services are subject to obsolescence, a potentially crippling lawsuit or possible change in regulations is brewing or top management is quitting, there isn’t much clarity on the company’s debt-paying ability.
Adding a sizable debt burden on top of the profit uncertainty will further expand the range of possible outcomes. Now, your bond may make all of its payments with plenty of cushion, or it may miss a payment or two, or it may not pay you its full face value at maturity. You just don’t know with much confidence how it will all turn out.
Permian Resources’ 8.0% Junior Subordinated Bonds due 2022, for example, which trade at 31, have a vast range of possible outcomes. The company is a highly leveraged oil exploration and production company subject to high capital spending requirements, volatile oil prices, dry holes, legal risks, rising interest rates and other risks. A few wrong turns of fate and it will go bankrupt, likely driving the bonds to near zero. However, if oil prices rise, they find a lot of oil and their drilling costs decline, with some luck the bonds could surge into the mid-80s or higher.
This very wide range of possible outcomes creates inefficient pricing, as investors can have very different views on what these bonds are actually worth. For the buyer of distressed bonds, this uncertainty and inefficiency are powerful sources of potentially high returns.
As a potential buyer, you have the luxury of time – you can simply wait. Wait until the price assumes an outcome that is about as bad as it’s likely to get, and then buy. As certainty increases, and if the outlook improves, the range of possible outcomes narrows and shifts upward – likely driving your bond’s price sharply higher.
In our next note in this series, we will delve into other reasons distressed bonds can provide attractive investment opportunities.