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 (BDI) and forward rates (FFAs) 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 (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
Navios Maritime (NM), for example, has callable bonds which mature in 2017 trading on the market right now which are yielding 15%. One could easily invest half an investment into these bonds and earn a theoretical 15% 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 8% for your efforts.
Scenario #1: Navios Maritime Rockets Upwards
In terms of principal, if Navios shoots to the moon, there will be large gains to the debt, but large losses to the shorted shares. If designed properly, the bond arbitrageur should nearly break even, but would likely have a small loss. The key is that losses are not limited in this case because the bonds are not convertible.
Scenario #2: Navios Maritime 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: Navios Maritime Stays Even for Years
One half of your investment earns 15% while the other side loses the margin interest of 7%, resulting in almost 8% 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.
Note: Because most retail brokers do not allow shorting when stocks reach below a certain dollar price (often $2 or $3), sometimes stocks in a similar situation to Navios Maritime can see the shares fall just due to the inability for shorts to enter if it falls any further. In other words, if your only insurance policy is not going to be able to be purchased in the near future, in the present time the value of buying that insurance rises.
Additionally, due to the fact that the bonds are not convertible, it would be advisable for prospective bond arbitrageurs to buy out-of-the-money call options for a nickel to insure against the trade backfiring. Amazingly, this exact trade, if replicated by enough investors, is exactly what could potentially help save the company by keeping the bond value up.
Note: Because Navios Maritime currently pays a dividend of roughly 6%, the arbitrage trade doesn't work as well as it could in many cases and may not result in the profitable spread shown here, but the dividend in this case is in high jeopardy of being cut, so the numbers presented may be appropriate looking forward. Either way, the hedge of these high yielding bonds is the only really safe way to buy them. My personal belief is Navios will cut the dividend completely, but will not go bankrupt soon, if at all.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.