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As regular readers of my articles know, I am a proponent of looking across a company's capital structure for investing opportunities. But when searching for the best opportunities, it is important not to think that looking across a company's capital structure means only choosing the stock or the bond. Instead, investors who are open to building more creative positions can discover possibilities that others will fail to see.

The Hospital Corporation of America, also known as HCA, is an organization that, according to its website, employs nearly 200,000 people and owns and operates more than 250 hospitals and freestanding surgery centers in 20 U.S. states and in England. Roughly 4% to 5% of all inpatient care delivered in the United States is currently provided by HCA.

After being taken private in 2006, HCA once again returned to the public markets on March 10, 2011. On that day, it opened for trading at $31.20, not very far from where the stock price currently stands. The equity pays no regular dividend, but it did pay two special dividends in 2012 in the amounts of $2.00 and $2.50 per share.

In terms of the company's debt, HCA's corporate rating is B1/B+, and its senior unsecured debt is rated B3/B- by Moody's and S&P respectively. In the event of default, S&P currently expects a recovery of 0% to 10% (recovery rating of '6') on the senior unsecured notes, while Moody's expects a recovery of approximately 14% (Loss Given Default rating of '5').

For investors interested in a unique money-making opportunity in this hospital operator, the place to start is actually not with the stock or with senior unsecured notes. Instead, begin building your position with the senior secured, first-lien notes. More specifically, start with the recently issued 4.75% coupon, 5/1/2023 maturing note, CUSIP 404121AF2. This senior secured, first-lien note is rated Ba3/BB by Moody's and S&P respectively. In the case of Moody's, the Ba3 rating is one notch above the corporate family rating and three notches above the senior unsecured debt. For S&P, the BB rating is two notches above the corporate credit rating and four notches above the senior unsecured debt.

As you might assume, the expected recovery rates on the senior secured debt are much greater than those of the senior unsecured debt. The 5/1/2023 maturing note has a recovery rate of '1' by S&P, meaning an expected recovery of 90% to 100% in the event of default. Moody's has a "Loss Given Default" rating of 3 assigned to that note, implying a loss of 35% (recovery of 65%) in the event of default. As a result of the very high expected recovery for HCA's aforementioned senior secured note, investors who are interested in investing across multiple levels of HCA's capital structure currently have the opportunity to put together a very creative portfolio position. The position will have far less risk than a 100% equity allocation but also a much greater potential for return than the senior secured bonds can offer. Here is how to put the position together:

Let me start by saying that even though the trade can work with traditional retail investor size orders, it is better suited for larger institutional size orders. Therefore, I will use as an example an order size that is typically considered to be the lower end of an institutional bond purchase. A $100,000 face value purchase of the senior secured note, CUSIP 404121AF2, currently available for 100 cents on the dollar, yielding 4.75%, and maturing 5/1/2023 will pay $4,750 in interest on an annual basis. Moody's and S&P have expected recovery rates for this bond ranging from 65% to 100%. This means that in the event of default, investors should generally plan for losses of $0 to $35,000 on a $100,000 face value position.

According to S&P's October 22, 2012 "HCA Inc.'s Recovery Rating Profile," the senior secured, first-lien notes are secured by first-priority liens on "substantially all assets of the borrower and guarantors, other than accounts receivable." For accounts receivable, the senior secured first-lien notes are secured by a second-lien. Under a scenario in which holders of the senior secured notes take losses, equity shareholders of HCA will most likely see their shares go to zero. As a result of this, in order to hedge the potential losses of the senior secured notes, investors should purchase put options on shares of HCA.

At this time, the January 17, 2015 maturing $18 puts are asking $2.15. Investors purchasing $100,000 face value of the 4.75% coupon senior secured note at the recent asking price of 100 cents on the dollar will accrue approximately $10,138 by the expiration of the $18 HCA put options. By taking a portion of the accrued interest and purchasing January 17, 2015 expiring $18 put options, an investor can hedge away the risk to the senior secured bond position for more than two years and maintain a nearly risk-free return on the remaining interest earned.

Depending on whether you are inclined to believe Moody's or S&P's expectations for default, the amount you spend on the put options will vary. In the table below, I outline the current worst case scenario for how much you will spend, ex-commissions, on hedging the senior secured note using the expected recovery range of Moody's and S&P. I even included the details for a 40% loss on the bond in case the rating agencies are a bit too optimistic.

Expected Loss on Bond

Number of January 17, 2015 $18 Puts to Purchase

Cost of puts, Excluding Commissions

0%

0

$0

5%

3

$645

10%

6

$1,290

15%

9

$1,935

20%

12

$2,580

25%

14

$3,010

30%

17

$3,655

35%

20

$4,300

40%

23

$4,945

The reason I stated that the amounts outlined in the table are the worst case scenario for how much you will spend, ex-commissions, on hedging HCA's senior secured note is because I think it is entirely possible to find hidden liquidity on the January 17, 2015 expiring $18 put option. I have more to say about hidden liquidity in Chapter 7 of my book, The 5 Fundamentals of Building a Retirement Portfolio. But for the purposes of this article, keep in mind that on wide bid-ask spreads, you need not always settle for the price being offered at the bid or the ask. It is often possible to find liquidity somewhere in between. With a $1 spread separating the bid and ask ($1.15 by $2.15) for HCA's January 17, 2015 $18 puts, I think the put buyer should try to find hidden liquidity in the $1.85 to $2.10 range.

As you can see in the table above, the cost of hedging up to a 40% expected loss on the senior secured note through January 2015 is much less than the accrued interest earned on the senior secured note. This is an opportunity that may not present itself for too much longer if one of three things happens: market-wide volatility increases; HCA's company-specific volatility, as measured through the option chain's implied volatilities, increases; or HCA's stock price drops, thereby increasing the premiums associated with the options. If you are interested in this hedging strategy, act quickly.

Depending on your perspective, you will likely view the difference between the accrued interest on the senior secured note and the premium spent on the puts in different ways. Investors who typically favor fixed income positions in their portfolios may be content with a hedged bond position resulting in a lower yield. Even after hedging the position for the expected loss in the event of default, the remaining accrued interest still leaves investors with yields that are higher than Treasuries (NYSEARCA:TLT) and higher than the yield on the S&P 500 (NYSEARCA:SPY) and Dow Jones Industrial Average (NYSEARCA:DIA). For bond-oriented investors, this may be sufficient for a hedged senior secured note. And after the put options expire in 2015, investors could then decide whether to again hedge the position for an additional couple of years or whether the perceived credit risk has been reduced to a level that doesn't warrant hedging the bond.

For the fixed-income leaning investor curious about the HCA senior secured note's annualized return after hedging away the bond's risk through January 17, 2015, it would look like this:

Expected Loss on Bond

Cost of puts, Excluding Commissions

Remaining Portion of $10,138 in Accrued Interest After Purchasing Puts

Annualized return on $100,000 Face Value Bond Position Through January 2015 Option Expiration

0%

$0

$10,138

4.75%

5%

$645

$9,493

4.45%

10%

$1,290

$8,848

4.15%

15%

$1,935

$8,203

3.84%

20%

$2,580

$7,558

3.54%

25%

$3,010

$7,128

3.34%

30%

$3,655

$6,483

3.04%

35%

$4,300

$5,838

2.74%

40%

$4,945

$5,193

2.43%

While the ability to create this type of portfolio position across a company's bonds and options is likely an enticing proposition for many investors, equity-oriented investors may be looking to build a position with a bit more potential upside. This is where the unique money-making opportunity in HCA comes into play. It is not always easy to find senior secured notes available for trading on the secondary corporate bond market. HCA's aforementioned note is one exception. And because senior secured notes typically come with significantly higher recovery rates than senior unsecured notes, it is not necessary to hedge them to the same extent an investor would want to hedge senior unsecured notes. When combining this with the current favorable pricing on HCA's January 17, 2015 maturing $18 put options, there is sufficient money left over for investors to take a position in the company's equity.

By using the left over money (difference between accrued interest and put option premium paid) to take a position in the lower reaches of HCA's capital structure, an investor would be using a hedged senior secured bond position to fund the equity stake. Again, this is possible due to the current favorable pricing on the options and the fact that HCA actually currently has senior secured notes trading on the secondary corporate bond market. This opportunity may not present itself for too much longer.

In S&P's aforementioned report "HCA Inc.'s Recovery Rating Profile," the rating agency notes that it believes HCA would reorganize in the event of default rather than cease operations. This would, in turn, lead to a greater recovery value. I am inclined to agree and will therefore use S&P's lower estimate of a 90% recovery rate when outlining the possibilities for equity-oriented investors wishing to use HCA's senior secured note to fund an equity stake in the company.

As shown in both previous tables, the cost of hedging an expected 10% loss on the secured senior note using the $18 January 17, 2015 expiring puts is $1,290. While an income-oriented investor may wish to leave the remaining accrued interest untouched, thereby realizing an annualized return of 4.15% on the bond (through January 17, 2015), the equity-oriented investor may wish to use the remaining $8,848 in bond interest that will accrue between now and January 17, 2015 to get long the stock. Of course, when pulling an amount of future expected interest income from your available cash, there is the risk that the company will default prior to your receiving payment of that future expected interest income. But if you are using expected future accrued interest to fund an equity stake, you are implicitly assuming that the company will not default at any time in the near future. After all, if you are worried about the company defaulting on its debt obligations before you receive the interest payments from the bond, then you should not be taking an equity stake in the company (equity is further down the capital structure and will suffer much greater losses than the senior secured bonds).

So the question for the equity-oriented investor is in what way to establish the equity stake in HCA using the $8,848 in income that the senior secured bond will accrue between now and January 2015's option expiration (less the cost of the $18 puts purchased). While there are several ways to do this, two stand out to me as preferable.

First, you could use the $8,848 to purchase shares of HCA. At the recent closing price of $31.46, $8,848 would buy 281 shares. The potential unlimited upside from the equity stake could significantly enhance the total return of the initial $100,000 position in HCA. Additionally, selling covered calls against the position can also bring in more income over time. If covered call options is the route you want to take, you should consider purchasing an additional 19 shares so that you can sell covered calls against the entire position (three contracts) versus only being able to sell two contracts at a time (covering only 200 of the 281 shares). Remember that one option contract usually equals 100 shares of a stock, and in the case of HCA, it currently does.

Another possibility is to use a call option spread, allowing you to leverage the $8,848. Instead of purchasing just 281 shares with the $8,848, you could, for example, purchase six January 17, 2015 $20 call options at a price of $14.60. This would cost $8,760, ex-commissions, and provide exposure to 600 shares worth of HCA at an exercised cost basis of $34.60. By selling six January 17, 2015 expiring $40 calls against the long call position at the current bid of $3.30, you would collect $1,980, hedge 22.60% of the long call position, and still allow for an additional upside of $5.40 per share ($40 strike price minus $34.60 exercised cost basis). On 600 shares, that would be an additional $3,240, bringing the total possible return on the call option position to $5,220 ($1,980 plus $3,240, ex-commissions). That would be a 59.59% return on the equity exposure of the HCA position.

If you were to realize the maximum profit on the option position, you would then realize a total return of $14,068, ex-commissions, on the $100,000 initial investment in HCA. This is calculated by subtracting the cost of the put option hedge on the bond position ($1,290) from the accrued bond interest ($10,138) and then adding that amount ($8,848) to the maximum possible profit on the bull call spread ($5,220). The $14,068 profit would be realized if HCA's stock closed above $40 on January 17, 2015. This would bring the annualized return on the total position in HCA to 6.59%, versus the 4.75% an unhedged position in the senior secured note would realize and the 4.15% annualized return the previously described hedged position in the senior secured note would realize.

On the downside, by using the senior secured note to fund an equity stake (either directly or via the options) you run the risk of losing the entire $8,848 of interest the bond will accrue. If this occurs, you would make no money over a roughly 25-month time period. But the risk to the $100,000 initial investment is zero assuming no HCA default and virtually zero in the event of a default on the bond. I say virtually zero rather than zero because there is the risk that one or both of the credit rating agencies are wrong in their expected loss assessments, thereby resulting in a bond position that is not sufficiently hedged.

There are several different ways to play this unique money-making opportunity in HCA. The amount of the initial investment, the expected loss on the bond used when constructing the trade, and the options strike prices chosen for the equity-side of the investment will all change the final outcome. But perhaps most importantly, be aware that if you wait too long to create the bond-option-equity position in HCA, the opportunity may disappear as bond prices, option premiums, and equity prices adjust.

In the zero-interest-rate environment in which we operate, any strategy that can add a few percentage points of alpha without taking excess risk is one that is absolutely worth paying attention to. The strategy outlined in this article, whereby a senior secured bond position is simultaneously hedged and used to provide equity exposure to the same company is an example of such an opportunity and should be strongly considered by every investor.

Source: A Unique Money-Making Opportunity In HCA