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I have previously highlighted my interest in corporate debt in my premium posts – there were incredible offers in the secondary markets in the latter part of 2008. This year, unless the world economy completely collapses, corporate debt continues to offer some very attractive opportunities. The debt issues that interest me fall into four broad categories: solid companies whose debt is selling cheaply because of the overall level of concern in the credit markets; financials in which the government now has equity; speculative plays on companies which should eventually recover with the broader market; and bets that the government will not let US automakers fail.
First, there are quite a few solid companies whose debt is selling at attractive prices. US Steel (X), with solid cash flow and a debt-equity ratio of 55%, has 7% bonds maturing in 2018 (rated BB+ by S&P and Baa3 by Moody’s) which yield 11.3% (CUSIP 912656AG0). Similarly, Freeport-McMoRan (FCX) 8.375% senior notes, rated BBB- and Ba2, have a yield to maturity (2017) of 10.7% (CUSIP 35671DAS4). Both companies should survive the downturn; purchasing their debt now allows you to lock in better than 10% returns for years with relatively little risk. There are better returns out there, but these offer a nice, relatively safe foundation which clearly beats the return on Treasuries.
Second, an investor can take some shelter by buying the debt of corporations in which the government has already taken a huge equity position. In effect, the government would have to lose its equity stake before the credit position is threatened. Citigroup (C) is an obvious example of this case; Citigroup 5.625% notes, maturing in 2012, rated A- by S&P and A3 by Moody’s, yield 14.1% (CUSIP 172967BP5). Additional infusions of capital or conversions into common stock will dilute equity holdings, but will not harm creditors.
Third, there are some smaller companies with strong prospects which should be able to weather the current storm – their bonds offer good returns on investment with less risk than their equity. One example of such is Royal Caribbean (RCL). Though its shares have taken a beating, recently trading at $6, and 2009 promises to be a very difficult year, the cruise line’s prospects should improve as the economy does. Its trailing 12-month debt-equity ratio is 91% – not great, but there are many worse. Even if it runs into trouble, Royal Caribbean has significant tangible assets. Royal Caribbean’s 8.0% senior notes, which mature in mid-2010, yield 23.6% (CUSIP 780153AN2). They are rated BB and Ba2.
Fourth, at the very speculative end, is a play on the assessment that the government will not let all (or any?) of the big automakers fail. This is clearly more a political call than a financial one, but, if correct, could lock in very healthy returns. Financially, the automakers are far from being in good shape and the yield on their debt reflects that fact. Ford (F) is perhaps the best of the three; even so, its 9.5% notes maturing in 2011, rated CCC- and Ca, yield 61% (CUSIP 345370AZ8). GM (GM) debt, arguably more risky, yields up to double that. If you are confident that the government will bail out the auto industry, these bonds are worth a look.
There are no sure deals, especially in the current environment, and each of these fixed income investments involves a different level and form of risk. In most cases, however, buying this debt is significantly less risky than purchasing the corresponding stocks. Even if these corporations go into bankruptcy, which I consider unlikely, creditors usually recover at least some of their investment while stockholders normally lose all.
Disclosure: The author holds fixed income positions in Freeport-McMoRan, Royal Caribbean, GM, and FMCC, among others.
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This article has 24 comments:
As to X and FCX, I don't know that I see much of a reason to buy their debt given how beaten down their common stock is right now. X is selling at $17.50 right now --- so long as they survive over the course of the next 10 years, there's probably a good 100% - 500% return in there somewhere. If they don't survive, buying their debt isn't exactly a good investment. If they matured in 2011, it might make sense, but with a maturity in 2018, I can't see much of a reason to buy the bonds over the common stock. (For full disclosure purposes, I recently went long on X).
I agree with Larry that the selections you chose to highlight are a bit on the risky side. They are perhaps closer to the risk of the common equity in more stable companies. Yet, they illustrate how an opportunity has opened up to build a bond portfolio with baked-in double-digit returns. Such an opportunity usually comes only once every 20-30 years.
Yet, if the last 10 yrs contain a lesson to be learned, it is that people who chase the big returns often lose big. Those of us with retirements to think about might consider the beauty of earning 7-8% every year with almost no risk of losing half your money in a 2008 repeat.
Um...what exactly do you think IS happening??? I wouldn't touch debt with 30-foot pole!!! Very few companies will be able to handle their debt, if they don't have continuing positive free cash flow through this. And that's not many companies at all right now!!
The great advantage of bonds (not available to the average person) is that if you buy enough of them, you do get a significant say in the terms of any bankruptcy. If that's your hope, it's better to be with an activist manager than to try to do this on your own with a few thousand (or million) to invest.
It does not take a crystal ball to know that in the next few years that rates will go up significantly. The US government is borrowing huge amounts on a short term basis, and even buying back its long bonds to borrow more on the short end. Although it criticizes consumers who opted into flukey mortgages, the US is the ultimate ARMS borrower, refinancing long debt with short debt for the quick satisfaction of temporarily suppressing long rates.
Is that the environment in which to commit long term money to any bond? No way, except for a quick an nimble speculation.
Long-termers should stay in cash, and start buying the stocks of great companies which are on sale. If you want to play with bonds, wait two years and you will get munis at 8-12%, because state and local governments have no way of catching up with their debts and unfinded pension liabilities.
LordD
On Mar 02 02:11 PM The Mad Hedge Fund Trader wrote:
> Here's another idea. The US is turning into Europe. Think high taxes,
> high unemployment, more government involvement in everything, and
> much lower growth. That is the message the markets are telling us
> by retreating to the 6,000 handle, levels not seen since 1996, and
> down 54% from the peak only 17 months ago. Equity prices are shrinking
> to multiples in line with a permanently lower long term growth rate
> of maybe 2%, a shadow of the 5% rate seen for much of this decade.
> Maybe this is what mature economies are supposed to look like. If
> you do buy American stocks, only buy the ones that are really foreign
> stocks with American sounding names. Microsoft (seekingalpha.com/symbo...),
> Intel (seekingalpha.com/symbo...), Oracle, (seekingalpha.com/symbo...),
> Cisco (seekingalpha.com/symbo...) all get 60%-70% of their
> profits from overseas where high growth rates have migrated. I think
> I’ll move to Tahiti and live off of coconuts and freshly speared
> fish, wearing only a loin cloth.
In addition to the interest, bonds also have capital appreciation upside - as interest rates fall.
FCX bonds have been recommended by many analysts. Will generally urge people to look at bonds - LQD is a good ETF for high grade bonds.
Would avoid auto and financial bonds, but remember lot of recent finance bonds are guaranteed by the Fed.
SPDR S&P Dividend (SDY)
PowerShares Financial Preferred (PGF)
iShares S&P National Municipal Bond (MUB)
Nuveen Insured Municipal Opportunity Fund Inc. (NIO)
iShares Barclays 20+ Year Treas Bond (TLT)
iShares iBoxx $ High Yield Corporate Bd (HYG)
SPDR Barclays Capital High Yield Bond (JNK)
Nuveen Investment Quality Municipal Fund Inc. (NQM)
Nicholas-Applegate Convertible & Income Fund (NCV)
On Mar 03 12:45 AM Jake2 wrote:
> With all of the talk about debt and bonds, only one mention of bond
> funds: LQD by SB-tiger. Are there any other bond funds out there
> worth looking at, such as Vanguard Total Bond, for example, or some
> other fund?
Also the financials like BAC PRU, are paying a good coupon rate. I hope the autor writes articles this again.
Please try to send this article to other investors to educate them in the coprporate bond market
Hi-yield, investment grade, etc.
However, with lower prices many are now at hi-yield status.
Due diligence is the word.
I have been slowly dipping into some of the PIMCO funds.
Disclosurers: (PTY), (ACG).
On Mar 03 12:45 AM Jake2 wrote:
> With all of the talk about debt and bonds, only one mention of bond
> funds: LQD by SB-tiger. Are there any other bond funds out there
> worth looking at, such as Vanguard Total Bond, for example, or some
> other fund?
All the posts recommending review of the indentures are spot on. But that's no different from the research any investor should do on a potential equity investment--if the cash flow stream is subject to interruption by something you can identify within the financial statements, and you assess that the likelihood is low, then you're much less apt to lose money on a debt purchase, notwithstanding the yield.
Yields and ratings are put in place to provide investors with consistent evaluation criteria. True, all of these recommendations are risky, but their ratings bear out the risk. Unlike ratings on CDOs and MBSs issued in 2005 and 2006.
Thank you again for pointing out these alternative investment options.
seekingalpha.com/artic...
Debt, like equity, is far from a monolithic investment class. Actually, I take the philosophical view that everything is debt, and either you get paid back your principal (i.e. initial investment) and some interest (i.e. dividends, interest payments, capital gains). There is debt that trades like equity (often distressed, and quoted out of 100 on Wall St.), and equity that has most of the characteristics of debt (think utilities that have stable cash flows, and that are not overly leverered).
This is more the case now than ever before, given how the capital markets have traded recently. The traditional moniker of "investment grade/high grade" vs. "junk/high yield" are not clear lines of distinction. Often, there is debt that is what I call "cuspy," and has an interesting yield that makes it quasi high grade/high yield. It blurs.
What has historically made these distinctions important was the class of investor, not the investment itself. There are mutual funds and insurance companies that could only invest in agency rated investment grade debt. While I could go on a whole tangent about how effective the agencies are at this, I'll refrain. (Perhaps in my blog one day!)
The names you listed above, for the moment, do not seem to be distressed, at all. They seem like sound companies that have adequate cash flows. Cash flows, in reality, are all that matter. Both for debt and equity.
Cash flows for debt, however, are a bit more important, because it tells us (according to legal documents known as indentures or credit agreements) if the debt is current, and clear of violating covenants. Basically, it is somewhat black and white -- either you are paying your coupons on time, and don't have too much debt, or you are not. Equity, on the other hand, has no such obligations. The company can increase or decrease its leverage, and the average equity holder has no say in the matter.
So how does one figure out of the corporate credit is worthwhile using cash flows? Easy (at least conceptually, the actual exercise involves a bit of analytical work). Take a companies net income (as reported), and add back non-cash items (e.g. depreciation and amortization), add back tax (because interest expense is often tax deductible), and add back interest payments. Also, for analytical purposes, add back "one time" expenses (e.g. restructuring costs, noisy/dirty/weird stuff, etc.)
This measure is often called "EBITDA" by Wall St. It was invented by Drexel Burnham in the days of high yield. It is basically the clean(est) cash earnings of a company regardless of how it is financed (i.e. debt vs. equity).
Take the EBITDA, and deduct capital expenditures (costs associated with maintaining the property, plant, and equipment -- think of the plant costs that are required to run a factory, like a new machine). Make sure the capital expenditures are "steady state" or "maintenance." This means don't include any capital expenditures required to grow the company, like an extra machine to make more widgets.
This EBITDA less Capex formula is a magic number in many ways to debt investors. This is the cash flow that can be used to make cash coupon payments. If this number is not much higher than interest expense, then there is risk. If the number is multiples higher, as they often are in investment grade companies, then the debt is often viewed as low(er) risk. This is all a rule of thumb. Bear in mind I'm only giving the basic fundamentals, not all the dirty details behind the numbers.
In addition to that exercise, other things to be on the look out for is "seniority" of the debt. The more senior it is, the more likely it is to get paid its principal back. Finally, the maturity profile is the third main component (from my perspective). It is possible to invest in junior debt that has a higher coupon than more senior debt, but have it be "safer" because it comes due before the senior debt, and hence less risky in some ways.
Anyway, investing in debt is great if one picks up these things first. The nuances are what makes it an art vs. a science. Just like stock picking... but in some ways the requirements to be precise invite greater demands on the analysis.
I agree now is a fantastic time to be looking at debt. Barring WW III or some nuclear devastation, we are looking at some fantastic yields. I understand that risk free rates will rise in the future in order to keep inflation in check, but I'd imagine the prices of these debt securities will risk, dropping the yield, but increasing the capital gains (which is VERY nice).
Go forth and invest. But invest safely!
C is a little to crazy for me. Yes, the government appears to be guarenteeing senior debt, but who knows down the road?
Don't forget, there is always a reason that certain yields are where they are and certain bond prices are where they are. The higher the return, the higher the perceived risk, that is just how it goes in life. If the same bond yielding 2% has the same risk as a bond at 23%, who the heck would pick the the 2%. As Bill Parcell's says, "You are what your record says you are". If you are a bond selling at a distressed price and with a high yield, then that is exactly what you are...
BTW, what is everyone's 2 cents on GE debt? Wil it be covered come "the end of the world"? Government already supports it. If the break up GE, senior debt will be okay...
I bet the price is getting beat up the last 48 hours...