Bond Default Arbitrage Opportunity: DryShips

| About: DryShips Inc. (DRYS)

The Industry

The shipping industry is a particularly interesting one to follow. Commodity prices and the supply/demand of ships can lend significant insight into how the industry will perform in the future. Additionally, drybulk shipping rates and forward rates can help one predict company earnings with great precision. But with the sector and economy in such a generally poor malaise, how do the most professional lenders and investors of the world make money in this sector?

Shipping companies are currently offering some of the highest-yielding bonds in the world. This means the market is pricing the sector for a near total collapse. For example, General Maritime (NYSE:GMR) has bonds due in 2017 which are yielding over 100%. So assuming you have a company which you feel is going to die a slow death, how can you design an investment so that you can maximize both return and safety?

Designing the Bond Default Arbitrage

DryShips (NASDAQ:DRYS), for example, has convertible bonds which mature in 2014 trading on the market right now which are yielding 13.63%. One could easily invest half an investment into these bonds and earn a theoretical 13.63% yield. At the same time, one could short shares or buy puts on the shares of the company. Shorting the shares will result in retail investors having to pay a margin rate to borrow the shares (roughly 7% for most investors these days), which is totally covered from the interest earned by buying the bonds with a profitable spread of more than 6% for your efforts.

Scenario #1: DryShips Rockets Upwards

In terms of principal, if DryShips shoots to the moon, there will be large gains to the debt due to the convertible features of the debt, but large losses to the shorted shares. If designed properly, the bond arbitrageur should nearly break even, but could have a small loss. The key is that losses are limited due to the convertibility of the bonds.

Scenario #2: DryShips Goes Bankrupt

The debt would not result in a total loss. Bond holders would likely still earn at a minimum 20-30 cents on the dollar. Meanwhile, the short position would be total profit. This would be the ideal scenario.

Scenario #3: DryShips Stays Even for Years

One half of your investment earns 13.63%, while the other side loses the margin interest of 7%, resulting in almost 7% profit per year. The key here is that if puts are used instead of shorting shares, the puts must be chosen in a manner in which time value decay is not greater than 7% per year.

Special Note

Because DryShips owns a controlling interest in Ocean Rig (NASDAQ:ORIG), one may also be able to effectively hedge the bond default arbitrage by taking a position in Ocean Rig. If one believes that Ocean Rig holds all the value in the overall company, then shorting DRYS can be hedged by taking on a long position in ORIG. This in fact could make for an interesting trade in itself: shorting DRYS and buying ORIG.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.