Chesapeake: The Riskless Trade Everybody Loves

| About: Chesapeake Energy (CHK)

Summary

Chesapeake just produced an incredible risk-free trade.

However, Chesapeake seems to only have told us about it after the fact.

This article describes the trade and its implications.

Click to enlarge

Chesapeake also has nice buildings to go with the Chesapeake Arena

This Friday an interesting Chesapeake Energy (NYSE:CHK) 8-K hit EDGARonline. It's a short 8-K so I'll transcribe the important part here:

Chesapeake Energy Corporation (the "Company") has entered into privately negotiated purchase and exchange agreements under which it has and will exchange (the "Exchanges") in reliance on Section 3(a)(9) of the Securities Act of 1933, as amended (the "Securities Act"), shares of the Company's common stock, par value $0.01 per share (the "Common Stock") for outstanding 2.5% Contingent Convertible Senior Notes due 2037 (with May 2017 put rights) and 6.5% Senior Notes due 2017 (collectively, the "Outstanding Senior Notes") of the Company. As of March 18, 2016, the Company has issued or agreed to issue an aggregate of 17,255,347 shares of Common Stock, representing approximately 2.6% of the Company's outstanding Common Stock, in exchange for $105.0 million aggregate principal amount of its Outstanding Senior Notes.

What do we have here? Given CHK's recent share and bond behavior, we have the description of what was a riskless trade for those taking it. The riskless trade consisted in:

  • Buying those 2017, 2037 bond issues.
  • Exchanging them for shares.
  • Selling the shares in the market.

Why was the trade riskless? Because:

  • Those 2017, 2037 bonds were trading at very depressed levels, like the rest of CHK's debt.
  • The principal amount retired/number of shares is the same as issuing shares at ~$6.09.
  • CHK stock traded over $5 per share on high volume 11 market sessions ago, and did so for 3 market sessions, including the market session on Friday.
  • $5/$6.09 = ~82.1 cents paid per dollar of principal on those bonds. Of course 82 cents is a high price for a CHK bond.

This riskless trade probably explains why those bond issues fared so well, consider their recent behavior:

Source: Finra/Morningstar, CHK 2037 2.5%

Source: Finra/Morningstar, CHK 2017 6.5%

At 75.5 cents (both bonds converged to around this price), these bonds recovered nearly all their losses in the last year.

Now consider how other CHK bonds with close maturities, but not involved in these deals, fared:

Source: Finra/Morningstar, CHK 2038 2.25%

Source: Finra/Morningstar, CHK 2018 7.25%

While these other bonds also had nice rallies, along with the entire high yield market, they fell far short of the rallies enjoyed by the 2017/2037 bonds. Obviously, this happened because at this point there was no way to turn these other bonds into a deal where they could be offloaded at ~82 cents on the dollar.

Unfortunately, this riskless trade was probably not available to you. After all, as the 8-K says, the trade consisted in "privately negotiated purchase and exchange agreements" (emphasis is mine). Someone made a lot of money here, but it wasn't you. One wonders why the company didn't make these offers in the public market. Perhaps the rules don't allow it? Perhaps if this was public and anyone could exchange their debt for shares, the shares would never be high enough for someone to profit? Never mind.

Why Is The Trade Loved By Everyone?

Even if the whole thing seemed set up for someone else to make a lot of money, this is a trade to be loved, because:

  • It allows for some debt reduction.
  • It means the company issued shares at $6.09 without "disturbing" the equity market. As I've said in the comments to my previous articles, issuing shares while the equity craze goes on increases the likelihood that CHK will survive this cycle. Of course issuing shares for cash is even better. But this is the next-best possibility as it reduces 2017 maturities somewhat.

Conclusion

Someone made a lot of money in CHK bonds out of the possibility of negotiating privately with the company for a sweet deal. I find the whole thing mildly repulsive given the riskless nature of the trade it produced for those in on the offer. If this is legal, then this is legal insider trading -- unless every owner of the 2017/2037 bonds was informed at the same time.

That the 8-K now says that CHK might exchange more of these bonds on these terms ("under which it has and will exchange", emphasis is mine) is rather irrelevant. The riskless trade was produced by the ability to buy the bonds in the market while other market participants were un-aware of the deal. Depending on whether all holders of the bonds were informed of the possible exchange, there could be grounds for a lawsuit here (but it probably won't happen since while other bondholders in the same bonds could perhaps not be informed, they'd still have profited from it by seeing their bonds go up).

However, I must also say that this type of exchange is a mild positive for CHK's chances of survival, since it allowed for the issuance of more equity, debt reduction (at a rather low discount given prevailing CHK bond prices), and some relief to 2017 debt maturities.

On the other hand, these exchanges provided for selling pressure on CHK stock, and might provide for more of it if more bonds get involved or if the exchanges are opened to the public in general.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short calls on CHK.