Seeking Alpha's "Pro" articles always provide plenty of food for thought. I even once took advantage of a trade idea I found in a "Pro" article, which turned out to be a wonderful trade. I recently read the SA Pro article, "Caesars Entertainment Equity Still Has Essentially No Value: A Capital Structure Arbitrage Trade." The article did a nice job outlining some of Caesars Entertainment's (CZR) fundamentals and presenting a capital structure arbitrage trade to consider.
The arbitrage trade presented was the following:
- Sell short 1,000 shares of CZR for $15,170 and a ~7% annual cost to borrow.
- Buy 20 $1,000 par value December 2018 bonds at $615 for $12,300 plus accrued interest.
- Buy 10 Jan 2014 $20 CZR call options for $1,650.
The author continued:
"This would result in a total outlay of $13,950 + accrued interest. Of course, an investor could change the proportions and the amounts of this trade, but under these parameters and excluding accrued interest, let's look at what could happen:
- The investor would have a maximum gain of ~160% on the total outlay if the stock went to $0 and the bonds went back to $1000.
- If the stock went to $0 and the bonds went to $100, the investor would gain ~32%.
- If the stock went to $20 and the bonds went back to $1000, the investor would gain ~18%."
Before continuing I would like to clarify something that might confuse some readers in the quoted text. There was an inconsistency within the bullet points pertaining to the possible price of the bonds. The second set of bullet points refers to the bonds heading to $1,000, $100, and $1,000. Despite mentioning two different prices, my interpretation of what the author intended to convey for all three bullet points was the bonds returning to 100 cents-on-the-dollar ($1,000 par value). The $100 in bullet point two (second set of bullet points) may have caused some confusion given the bonds were purchased in bullet point two of the first set of bullet points for $615. Heading from $615 to $100 would imply a big loss on the bonds, and that doesn't appear to be what the author was intending to say. Perhaps this was simply a typo. But it needed to be pointed out before further examining the trade.
When I first looked at the arbitrage trade presented above, there were three things in particular that stood out to me. They are each important to keep in mind if you are considering arbitraging Caesars Entertainment's capital structure. First, the call options chosen for the trade expire in January 2014, slightly more than eight months after the article was written. If the call options expire before there is a resolution to Caesars' current woes, the short position would be left unhedged. This would force the trader to either unwind the three-part arbitrage position, leave it unhedged, or purchase more call options. In all three cases, the potential profit/loss scenarios of the original trade would change dramatically. Furthermore, should the trader decide to close the trade no later than January 2014's expiration, there is no guarantee the bonds will be anywhere close to par. In fact, it is entirely possible that Caesars is able to hold out until 2014 or 2015 before restructuring. Under that scenario, the company's bonds could easily remain depressed, the calls could easily expire worthless, and the short position could suddenly be unhedged with rising negative rebates (cost of borrowing shares) as the day of reckoning for Caesars draws closer.
Second, there is the assumption, in the article outlining the arbitrage play that the bonds will remain above 50 cents-on-the-dollar. If you read Moody's, S&P, and Fitch's takes on the recovery rates for non-first-lien Caesars bonds, you may decide to adjust that number much lower. The potential recovery rate on a bond, is, of course, also an important component of constructing an arbitrage trade involving a long call, short stock, long bond position. If I were putting on a capital structure arbitrage trade involving Caesars Entertainment, I would plan for a recovery rate that is much lower than 50%. This is true even if the bonds in question were the second-lien secured bonds. Should you construct the trade with a first-lien secured bond, however, then a much higher recovery rate could be used.
Third, if you are able to borrow shares to short, the annual cost-to-borrow could fluctuate wildly and end up far higher than the 7% assumed in the aforementioned article. This is especially true if you are only putting on a 1,000 share short position (as mentioned in the arbitrage example).
The entire crux of the aforementioned well-written article and intriguing idea for a trade rests on three assumptions that are anything but certain. I am a big believer in the fact that there is nothing guaranteed in the world of trading (unless you have inside information). Instead, a trader simply looks for opportunities in which the odds of success are notably on his or her side. In the case of the Caesars Entertainment capital structure arbitrage trade, the three aforementioned assumptions built into the trade create too much uncertainty, and therefore, do not, in my opinion, put the odds of success notably on the trader's side. Even though I am inclined to believe Moody's that the Caesars capital structure is unsustainable and that a distressed exchange is becoming ever more likely over the next two years, I think it is too risky to make an arbitrage bet that a resolution occurs before January 2014's options expiration.
When examining the options chain of Caesars Entertainment, the options market has created several opportunities for interesting arbitrage plays using the January 2014 expiring options that do not exist with the January 2015 options. Caesars Entertainment's woes are well known to the market. The options market appears to be telling us that Caesars makes it through January 2014 without restructuring. Of course, the market could be wrong. If you believe Caesars will find a resolution to its massive debt woes before the next eight months run their course, then the arbitrage play described in the aforementioned article is one to seriously consider. Otherwise, you will be setting yourself up for a potentially frustrating experience.