Capital structure arbitrage is a strategy to exploit relative mispricings of the securities of one company. A typical capital structure arbitrage trade might be to buy the bonds and short the common stock of the same company. The current low interest rate environment has created a capital structure arbitrage trade opportunity in the preferred and common stocks of Cedar Shopping Center (NYSE:CDR) and (CDR-A).
Yield investors have bid up the price of the preferred. The common stock trades around $4.60 with an annualized dividend of $0.36 for a yield of 7.8%. The preferred stock is $25 par value with an 8 7/8% dividend. The preferred currently trades at $25.24 which is a 9% strip yield after adjusting for accretion of the $0.5546875 dividend payable later this month. With the common stock trading at near 52 week lows and the preferred closer to the high end of its yearly range, the opportunity is to buy the common stock and short the preferred in equal dollar amounts that is buy 5.5 shares of common and short 1 share of preferred.
Typically, the price of the common and the preferred should move in the same direction. After all, they both represent claims on the earnings power of the same company. While this divergence in price movement can persist indefinitely if the mispricing corrects, the trade can be very profitable with minimal market exposure.
The reason that the trade is interesting is that the preferred stock is currently callable which limits the potential price appreciation on the short portion of the trade. In essence, an investor can create low cost options with high potential payoffs. As with any trade with optionality, the payoffs will vary under different scenarios. The first scenario is the static return. Since this position is negative carry, If both stock prices remain unchanged, this position will lose the dividend yield differential of 1.2%. The risk is if the divergences continues then the trade loses the carry and has a loss on the spread.
The bull scenario is that both stocks rise in price. The impetus for an increase in price can come from a variety of sources, improved operating results, lower interest rates, multiple expansion, etc. Since, the preferred is callable at the par value of $25 on thirty days notice the price appreciation is limited. The all time high for the preferred was just under $27. I view the maximum loss on the short portion of the trade as $1.75 per share. There is no corresponding cap on the price of the common stock so the potential profit on the position is great. The chart below is the payoff diagram for this scenario for common stock prices of $4.60 to $8. For simplicity, I have assumed that the pfd moves to the max loss instantly.
click on images to enlarge
The bear scenario is that both stocks fall in price. Again a decline in price can come from a number of factors, deteriorating operating results, rising interest rates, multiple contractions. The extreme case is bankruptcy. In a bankruptcy scenario both stocks go to recovery value which in this case would probably be zero. The return to an investor in the extreme case would be to lose the dividend differential. However, both stocks would trade down well before such an extreme event.
On the way down, the preferred will likely lose value faster as the common stock trades like an option on the company (Merton). The delta on that option declines as the value of the company falls. For an example of this effect, look at the behavior of the stock of companies in Chap. 11. At the depth of the financial crisis the preferred traded below $9.00. The chart below illustrates the relative price declines as both stocks moved lower during the crisis. Periods when the blue line is below the orange line show the preferred stock declining faster than the common stock.
CDR has been a takeover target in the past. This trade should be very successful if the company is acquired. The common stock should increase in value and the preferred should move down. If the buyer has superior credit, the preferred will likely be called at par. If the buyer is less creditworthy or the deal structure leaves the company highly leveraged, the preferred should decline.
The main risk is that CDR cuts the common dividend. However, the company is operating cash flow positive and I think a dividend cut is unlikely. Overall, the trade allows for substantial upside if the common stock moves up while limiting the risk on the downside. Plus, there is the potential for profit on the short side in the event of a credit dislocation as occurred in 2009.