As low interest rates have dominated the economy for the past few years, investors have chased yield into emerging markets, exotic products, and riskier credit investments. Investors flocked to convertible bonds for their equity-like characteristics and potentially higher yields. This environment has provided some interesting risk/reward opportunities, as required yields on traditionally high-yielding assets have become depressed and bonds have traded at premiums as companies reconfigured their capital structures.
Weyerhaeuser Company (WY) is an integrated forest products company with operations worldwide. The company primarily grows and harvests trees, develops and construct real estate and makes a range of forest products, and it is classified as a REIT.
I recommend purchasing the Weyerhaeuser Co Convertible Preferred 6.375% 7/1/2016 at its current price of $54.86 (par value $50.00) at a premium to par value of 9.72%.
To fund this purchase, I recommend selling short the Weyerhauser Co 6.95% 08/01/2017 high yield bond at its current price of $116.675 (at a premium to par value of 16.675%).
For ease of explanation, let's imagine a trade value of $100,000. Purchase 1823 shares of the Convertible Preferred, and sell short 86 of the 6.95% bonds on March 1, 2014. Purchasing the 6.375% CP will cost $100,009.78, and the proceeds from the WY 6.95% short sell will bring in $100,340.50, netting a $330.72 cash inflow on March 1, 2014.
WY CP 6.375% 07/01/2016
WY 6.95% 08/01/2017
An investor will then earn $0.7969 per share per quarter on the CP shares ($1452 per quarter on the $100,000 position) and be liable for the $34.375 coupon ($2956.25 semi-annually) on the 6.95% bond. Periodic cash flows will look as follows:
WY CP 6.375% 07/01/2016
WY 6.95% 08/01/2017
An investor will pay out $253.76 over the course of the life of the preferred (net loss of $50.752 per six months), and in July 2016 would close both positions. We then need to determine what the values of both the CP and the 6.95% bond will be in 2016. Assuming that both will converge towards par as maturity approaches, the price of the CP will be $50 per share at expiry. The WY 6.95% bond will require some more input to determine the closing price on 7/1/2016. Assuming the price of $116.675 today, the price of the bond with 2 coupon payments remaining should be lower than with 6 coupon payments remaining (assuming a constant required yield by investors).
Put another way, an investor will lose the 9% premium paid for the convertible preferred but will gain 10-11% of the 16% bond premium.
This exposes the investor to unknowns at the end of the preferred convertible's life. If we assume a constant yield to maturity (current price implies a 1.91% YTM on the 6.95% coupon bond), the price of the bond in July 2016 should be $1057.36. Assuming that the call option is not exercised and the value of the CP redeemed at par, a profit of $5,839 would be realized (+$96,772 for the redemption of the preferred and -$90,932 for the closing of the short bond position). Why have we gone through such pains to show a trade that will yield approximately $5,000 on a $200,000 gross investment over a period of 29 months? The call option in the preferred stock is essentially free because of the exorbitant premium on the 6.975% bond! According to the Black Scholes model, the option in the Weyerhaeuser convertible preferred should be valued at $2.25 (assuming historical volatility of 22.86% and aconstant dividend).
Therefore, if Weyerhaeuser Co's stock is able to increase 9% ($30 today to $33.10) in the next 29 months, the call option will begin to have intrinsic value, and the call option has the potential to meaningfully affect position PnL. The following figure shows a sensitivity analysis of the trade's profitability to the discount rate and the price of the equity at expiry.
The sensitivity analysis was calculated gross of cost of borrowing the bond. Assuming a 1.5% borrowing rate, all the above PnLs would be reduced by approximately $2708. In percentage terms, the annualized return on investment would lie between 1.88% (no equity movement and required yield on the 6.95% falling to near zero levels) and 21.89% (equity moves to $50 and discount rate increase to 3%)
Would you want to own WY equity?
I have highlighted a trade that could reasonably yield 350bps per year without the equity moving, but the trade becomes increasingly profitable if the convertible option is exercised advantageously (6.5% return per year if the stock increases to $38). As such, we will spend a brief time discussing the merits of WY as a company.
The company earned operating income of $747 million on $8.259 billion in revenue last year - an 8.8% operating margin. The company generates strong cash flows through its operations but it has spent a significant amount of capital in its investing and financing activities. It pays a significant dividend ($0.81/share) because of its REIT status, and has earned positive EPS every year since 2010.
WY can meet its short term obligations. It possesses a current ratio of 2.06x and a quick ratio of 1.24x. The total debt/equity of the company is 79.16x (down from 120x in 2012). This number is not as concerning because the debt is long term in nature. WY will not be paying down significant portions of its debt before 2017, so default seems like a low probability scenario, barring natural disasters, etc.
This strategy carries a number of risks, as does any strategy involving selling a fixed income instrument short. If interest rates decrease, the value of the long position will be little changed while the short position will increase in value, affecting profitability by as much as 20% from a 100bps move in the required yield. This seems unlikely as the Federal Reserve appears to only be seeking to apply upward pressure on interest rates, as they sit near the zero-bound.
Dividend risk is important because the value of the embedded call option will be affected by dividends paid. With a payout ratio of 85%, the value of the call option will likely be more volatile. This risk could be offset by selling a call option on WY stock (effectively creating a bull call spread) or buying a put option on WY stock.
If WY defaults on its debt, preferred stock will be lower in the capital structure than the senior unsecured debt. If the bond holders are able to recover a portion on their bond position, the trade will have potentially large losses.
The prices of high-yielding bonds have become inexplicably high as investors chase yield. For an investor willing to take hedged positions at these levels, there appears to be significant upside and an asymmetric risk/reward profile. Finally, any strategy using short selling and leverage should be carefully weighed and are not for everyone.