In recent weeks, coal stocks have resumed selling off, a process that began in early 2011 only to pause for a bit of consolidation over the past few months. Arch Coal (ACI), Patriot Coal (PCX), and James River Coal Company (JRCC) have now broken below their October 2011 lows. Alpha Natural Resources (ANR) and Peabody Energy (BTU) are fast approaching their October lows. Over the past few weeks, I have read numerous commentaries outlining the challenges facing the coal industry. In the end, the discussion frequently shifts towards the pros and cons of buying coal stocks. However, it should be noted that "buy-the-dip" is not an expression that just pertains to stocks, but it is an idea that can be applied to the fixed income market as well.
As coal stocks have been selling off over the past several weeks, the bonds of many of these companies have followed suit. If you've done your homework on the coal companies, are looking beyond the current challenges, and are favoring putting some money to work in that industry, spend some time thinking through exactly what types of returns you are hoping to achieve from an equity position in coal. Then, spend some time comparing the prospects of achieving your goals based on the current stock prices, as compared to the yields you can find in coal companies by looking further up the capital structure.
If you believe the equity of a company is worth an investment, but the bonds of that same company will help you achieve your goals in a more predictable way, often with less volatility and the implied safety of being higher up the capital structure, why wouldn't you at least consider the bonds?
Let's examine some of the bonds of the coal companies mentioned earlier in this article to see if any might be enticing:
Alpha Natural Resources' 6/1/2019 maturing, 6% coupon bond (CUSIP: 02076XAB8) is asking 95.1 cents on the dollar (6.869% yield-to-maturity before commissions). Furthermore, it has a call schedule that, at current prices, would be quite lucrative to the bond owner if the note were ever called. Moody's currently rates the note Ba3; S&P rates it BB.
Arch Coal's 10/1/2020 maturing, 7.25% coupon bond (CUSIP: 039380AC4) is asking 97.48 cents on the dollar (7.655% yield-to-maturity before commissions). Furthermore, it has a call schedule that, at current prices, would be quite lucrative to the bond owner if the note were ever called. Moody's currently rates the note B1; S&P rates it B+.
Patriot Coal's 4/30/2018 maturing, 8.25% coupon bond (CUSIP: 70336TAC8) is asking 90.45 cents on the dollar (10.386% yield-to-maturity before commissions). Furthermore, it has a call schedule that, at current prices, would be quite lucrative to the bond owner if the note were ever called. Moody's currently rates the note B3; S&P rates it B.
James River Coal Company's 4/1/2019 maturing, 7.875% coupon bond (CUSIP: 470355AG3) is asking 70.878 cents on the dollar (14.62% yield-to-maturity before commissions). Furthermore, it has a call schedule that, at current prices, would be quite lucrative to the bond owner if the note were ever called. Moody's currently rates the note B2; S&P rates it B+.
Peabody Energy's bonds have not pulled back like the bonds of the other four coal companies. While you can still pick up yields in the 4%-7% range for maturities ranging from 2016 through 2026, the health of Peabody's bonds tells me that, at least for now, this is the company to focus your efforts on if you are looking for equity exposure in coal.
Perhaps you are thinking that the risk of losing out on building a long-term, buy-and-hold position in the coal stocks is too great, even for bonds yielding up to 14%. I can understand the argument that if you want a buy-and-hold investment, you might miss out on purchasing the stocks at cheap prices while you own the bonds. I would counter this with a few thoughts:
First, clearly define your goals for the investment within the framework of a realistic future for these companies. If the credit ratings of these companies do not materially improve over the coming years, there is a good chance you will be able to roll over the current bonds into other high-yielding bonds.
Second, there is no guarantee that the companies will be able to drive earnings growth at a pace that will propel multiple expansion. If they cannot, would the returns from earnings growth alone (if there is earnings grow at all) be sufficient to help you meet your goals? Is the risk of a buy-and-hold position in the stocks worth the risk of missing out on the current yields being offered by the bonds? Your risk tolerance, time horizons, opinions on the industry, and investment goals will help determine the answers to these questions.
Third, sometimes creatively approaching a portfolio can help to mitigate the psychological challenges that come with investing. If you are experiencing cognitive dissonance from the thought of suddenly finding individual bonds appealing in companies of which you were tempted to the buy the equity, here are a couple ideas that might help:
Reinvest the coupon payments into the stock of the same company - For instance, if you own $10,000 face value of Patriot Coal's 8.25% coupon bond, take the $412.50 paid to you every six months and buy shares in the company's stock. Alternatively, if you are buying a bond at a discount, you could purchase the face value amount of the bond that equates to your intended investment ($10,000 intended investment, then buy $10,000 face value), take the difference saved from buying the bond at a discount, and purchase shares of the stock right away. For example, in the case of the Patriot Coal bond mentioned above, $10,000 face value purchased for 90.45 cents on the dollar will cost $9,045 (excluding commissions). You could consider taking the $955 saved from purchasing the bond at a discount and purchase shares of PCX with the money.
Purchase the bonds and simultaneously sell out-of-the money puts - Another idea for investors concerned about missing out on the potential upside from equities would be to purchase the bonds with, say, 75% of your intended total investment and sell out-of-the money puts on the stock with the remaining portion. At the moment, you can sell Alpha Natural Resources' September 22, 2012 $15 puts for $2.17. These puts, which are 8.42% out-of-the money, will return 14.46% in a little over six months if they expire worthless. If the puts are assigned, you will own shares of ANR worth 25% of your originally intended investment at a cost basis of $12.83 (excluding commissions). This cost basis would be 21.67% below ANR's recent price of $16.38.
In closing, keep in mind that when deciding a company is worth investing money in, there are alternatives to simply buying the stock. Especially among companies with junk-rated debt, it is possible that investing further up the capital structure, in a company's bonds, will provide returns that not only meet the goals you had for the stock but also exceed them. Don't be afraid to look at individual bonds, especially in companies in which you have determined the lowest part of the capital structure, common stock, is an acceptable investment.
Additional disclosure: I am long ANR bonds, although not the CUSIP mentioned in this article.