Monday, March 26, 2012

Where Do Junk Bonds Go To Die?

Sketching Out The Range Of Outcomes

Some bond investors buy bonds with the intention or at least strong possibility of selling them prior to maturity.  Other bond investors tend to buy bonds, put them away, and forget about them until they mature or default.  With investment grade bonds, the outcomes are fairly straight forward.  Most investment grade bonds are not callable and the overwhelming majority of them do not default.  In contrast, junk bonds have a wider range of outcomes which can materially affect an investor's returns.  In this post I will outline the more common cases and describe the implications for returns.

The simplest case is that some junk bonds will simply pay coupons until they reach maturity and then pay out the face amount of the bond.  Much like an investment grade bond, this is a "what you see is what you get" outcome.  Junk issuers either pay these bonds off with internally generated cash, or they refinance via the issuance of another security or loan.  Unless the issuer has materially improved its credit profile over time, maturities are usualy refinanced with new debt.  As a result, the likelihood of junk bonds simply paying off at maturity improves as the quality of the issuer and the health of the new-issue junk bond market goes up.

Another very common outcome is the issuer calling the bonds prior to maturity.  Most new issue junk bonds are sold with a call option starting 3 to 4 years prior to the scheduled maturity of the bonds.  The call option starts at a premium (usually equal to an additional coupon payment) and declines to par when the bonds are within a year of maturity.  While a call deprives the bond owner of future coupons, if you are typically buying junk at a discount to par then calls will enhance your yield.  For example, in the case of the STON bonds I discussed here the yield to maturity is about 11% while the yield to call (earliest possible call date) is 16%.

Less common, but not entirely infrequent are tender offers for junk bonds.  In these cases a junk issuer either wishes to reduce its outstanding debt or refinance prior to the date that the bonds in question are contractually eligible to be called at a fixed price.  In some cases, bonds which are tenedred for may be at a discount to par.  This is chiefly done by distressed issuers which are attempting to restructure outside of the bankruptcy process.  More commonly, bond tenders are done at a premium to par and often include a higher premium than the first fixed call price.  Today Lyondell Bassell (LYB) tendered for two of its outstanding series of bonds at call prices several points higher than its highest fixed call price (see  I typically seek to sell all of my bonds into a tender offer when it is at a premium because it is highly likely that the issuer will be calling the bonds at its earliest opportunity and the yield to tender offer is generally higher than the yield to call.

Finally, junk bonds can and do default or end up in situations which are tantamount to default.  Moody's data suggests that single B rated bonds have a 5 year cumulative default probability on the order of 20%, so we are not talking about rare occurences.  If a bond defaults it obviously impacts returns badly in the short term.  However, the ultimate effect on returns depends on the form the bankruptcy takes.  In many cases, investors who are willing to be patient receive cash, new bonds equity or some combination thereof that are worth a lot more than where the bonds trade at the time of default.  In some (rare) cases, the post-bankruptcy securities may be worth more than the par amount of the defaulted bonds.  When I end up holding a bond that appears likely to default (and typically before I even buy an otherwise OK junk bond), I usually perform an analysis to see what the company's financials look like after bankruptcy and estimate what my bonds would be worth if they were converted into the equity of the reorganized company.  If the recovery value is within reasonable distance of my purchase price, I am usually comfortable buying the bonds.  In some cases, it is possible to buy bonds that would be worth more post bankruptcy (although this also suggests that you should revisit your model to check for errors or faulty assumptions).

There are a few other possible outcomes for junk bonds, but they are rare.  The ones worth mentioning happen when a junk issuer is acquired by another company.  Most junk bonds have what is known as a "poison put" which gives bondholders the option to force the issuer to buy back the bonds at 101% of par.  If the merged issuer would be a worse credit, most investors will put their bonds to the issuer (I certainly would do so).  If the merged issuer is a better credit (as would be the case if a large, investment grade company bought a small, junk-rated issuer), the bonds generally trade at a significant premium to par and you may sell into the market rather than put the bonds to the issuer.

As always, please do not take anything written here as investment advice.  Do your own due diligence, take your own risks and consult your advisors.  You can lose money on this stuff.

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