100% Arbitrage Opportunity In Vanguard Natural Resources Revisited 3 Months Later

| About: Vanguard Natural (VNR)

Summary

This was one of the greatest trades from the oil panic.

There was only technical risk.

The best example of bond vs common stock inefficiency.

On March 3rd I wrote an article "100% Arbitrage Opportunity In Vanguard Natural Resources". The basic logic of the article was that the bonds were unfairly priced compared to the common stock. The common stock was still paying dividend as were the three outstanding preferred stocks, but only the bonds were safe from suspension.

The bond was trading at 10 cents on the dollar with an all time high ratio of market capitalization common stock divided by market capitalization bonds. As stated in the article this was a market mistake that provided a large arbitrage opportunity.

The trade

"Long the 7.875% unsecured bonds (cusip 92205CAA1) vs. short the common stock VNR." At the time of writing the article the common stock was trading at $2.15 while the bonds were trading with a large offer at $10.80.

Only the bonds payments are a must......

"VNR currently has nearly 130 million shares outstanding for a total market capitalization of nearly USD 270 million. It PAYS dividend of USD 0.36 per year or USD 46.8 million( an amount enough to buy the bonds at current prices). While I am 99% sure that this dividend is getting suspended, let's not forget that VNR has three outstanding preferred shares that have nearly 13 million shares outstanding and pay yearly dividend on average of USD1.92 per share that totals USD 25 million. From all the above dividends only the bond dividend (interest actually) is a must as stated in the prospectus"

The funny thing here is that exactly after the article was published on March 4th, the common stock made a sharp (and suspect) move up to $2.70, making this arbitrage widen further. Then on March 5th the common stock dividend and the preferred stock dividend were suspended. This was expected for almost everyone who monitored oil companies at the time. I have no idea what caused the short squeeze, but it was a gold mine for readers of the article, because some of the people were able to participate in this trade at the most extreme levels. There was a moment in time when the bond could have been purchased at $10.25 vs a short position in VNR at $2.65. I will use these prices later to determine the most probable return from this trade.

Where do we stand now and what is the return of the arbitrage trade proposed?

Let's first look at the indexed chart from Interactive Brokers software:

Click to enlarge

As I am writing this article on July 20th the common stock of VNR trades at $1.82 while the bonds trade with a bid at $43. The proposed trade in my arbitrage trader portfolio was $20000 long of the bonds vs. 11000 shares short the stock. The bonds have appreciated nearly 4 times while the common stock (taken at $2.65 just to make the results look better) has fallen almost 30%. The initial absolute dollar value of the hedge was around $50000 and the current profit including hard to borrow charges is nearly $65000.

Keeping in mind that this was an arbitrage trade the +100% return in 3 months while being hedged as much as possible sounds just terrific now. I still can not believe the market got this relation so wrong. And it was not the only bond that got so miserably valued vs the common stock.

This was a great way to benefit from the panic in oil companies. I'm sure some readers managed to buy the lows of a lot of energy stocks and hold for some great gains, but we won't hear much from the many who were stopped out. The above strategy minimizes directional risk and I did not need to catch the exact reversal in oil to profit. I will be glad to hear how every one involved in this arbitrage opportunity managed the trade, because I did a very poor job when looking at the numbers now.

Why the market was so wrong?

I still can't say for sure. It was a trend from all over the oil and gas sector. This kind of arbitrage is my number one winner from that period. A lot of my articles were about overvalued common stocks vs preferred stocks and bonds.

One explanation could be that people in general are used to trade the common stock and a big percentage of the investing community does not consider other instruments, but this is just a guess. The relative pricing of the bond vs the common stock made absolutely no sense from financial point of view. A simple basic financial logic, with 3 calculations and 30 minutes reading of the prospectus should have been enough to convince everyone of the mis-pricing. We can only hope for new situations like this, but they are practically impossible while the sentiment is so bullish.

Conclusion

Panic in the market can create arbitrage opportunities with large gains. I should be careful for what I wish for, but I as a trader I can only hope for more and more panic.

The really hard task is to switch from being a trader to being an investor. My simple advice is to pay attention to alternatives and don't be scared to switch to the best option. Switching from VNR common stock to bonds was the safest and most profitable thing to do.

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.