Coal stocks have been absolutely crushed over the past year. Given the recent unusually warm winter in the United States, low natural gas prices, and the EPA's proposed standard for new fossil-fuel-fired electric utility generating units, it's easy to come up with reasons to sell coal stocks. Furthermore, with natural gas futures trading near a decade low, it's also not surprising to find companies with natural gas exposure whose stocks are trading well off their highs of a year ago.
If you are an investor who is tempted to buy the dips in certain coal and natural gas stocks but are nervous about catching falling knives, you might be interested in first investing at the top of the capital structure before eventually working your way down. In other words, take a look at some of the bonds of the companies whose stocks you are thinking of buying. It's possible the yields will be high enough to meet or exceed the expectations you have for the stock over the coming years.
Below, I would like to highlight five bonds from some of the coal and natural gas companies often discussed in the financial media.
Peabody Energy's (BTU) senior unsecured note (CUSIP: 704549AH7) maturing 9/15/2020 has a 6.50% coupon and is asking 100.10 cents on the dollar (6.483% yield-to-maturity before commissions). It has a make whole call and pays interest semi-annually. Moody's currently rates the note Ba1; S&P rates it BB+.
Alpha Natural Resources' (ANR) senior unsecured note (CUSIP: 02076XAC6) maturing 6/1/2021 has a 6.25% coupon and is asking 90.75 cents on the dollar (7.675% yield-to-maturity before commissions). It pays interest semi-annually and has the following call schedule: make whole and an equity call at 106.25 until 6/1/2016, callable at 103.125 beginning 6/1/2016, callable at 102.083 beginning 6/1/2017, callable at 101.042 beginning 6/1/2018, and callable at 100 beginning 6/1/2019. Moody's currently rates the note Ba3; S&P rates it BB.
Chesapeake Energy's (CHK) senior unsecured note (CUSIP: 165167CG0) maturing 2/15/2021 has a 6.125% coupon and is asking 99.50 cents on the dollar (6.198% yield-to-maturity before commissions). It has a make whole call and pays interest semi-annually. Moody's currently rates the note Ba3; S&P rates it BB+.
CONSOL Energy's (CNX) senior unsecured note (CUSIP: 20854PAH2) maturing 3/1/2021 has a 6.375% coupon and is asking 95.98 cents on the dollar (6.988% yield-to-maturity before commissions). It pays interest semi-annually and has the following call schedule: make whole until 3/1/2016, callable at 103.188 beginning 3/1/2016, callable at 102.125 beginning 3/1/2017, callable at 101.062 beginning 3/1/2018, and callable at 100 beginning 3/1/2019. Moody's rates CONSOL's senior unsecured notes B1; S&P rates this note BB.
Range Resources' (RRC) senior subordinated note (CUSIP: 75281AAN9) maturing 8/15/2022 has a 5.00% coupon and is asking 99.94 cents on the dollar (5.007% yield-to-maturity before commissions). It pays interest semi-annually and has the following call schedule: make whole until 2/15/2017, callable at 102.50 beginning 2/15/2017, callable at 101.667 beginning 2/15/2018, callable at 100.833 beginning 2/15/2019, and callable at 100 beginning 2/15/2020. Moody's currently rates the note Ba3; S&P rates it BB.
I would like to note that all five of the corporate bonds mentioned above have "junk" ratings from Moody's and S&P. Perhaps that makes you a bit nervous. If you've done your due diligence on any of the companies mentioned above and believe an investment in the company is worthwhile, think about the following when deciding whether or not to purchase the stock:
1. If it makes you nervous to purchase the bond because of the risk of default, what do you think will happen to the stock if the company defaults on its debt obligations? Do you really think the bondholders will suffer a default while the shareholders will avoid any kind of severe blow to their investments?
2. Will the yields currently being offered satisfy your goals with respect to an investment in these companies? And, if not, is the extra return you are hoping for above and beyond the current bond yields worth the risk of moving down the capital structure? For example, if you are hoping for a 9% average annual return on your investment in Alpha Natural Resources, is it worth the risk of investing in the stock to go after the extra 1.325%? Or, is the 7.675% annual yield from the bond sufficient from a risk-adjusted perspective?
3. If yields on the bonds are not entirely satisfactory, perhaps a combination of buying the bonds and reinvesting the coupon payments into the stock will make up for the difference between your expectations for the investment and the yields currently being offered. For example, a $20,000 investment in CONSOL Energy's 6.375% bond mentioned above would provide $637.50 every six months. That $637.50 could then be reinvested in the stock. You wouldn't be buying very many shares with the coupon payments, but for investors who prefer to reinvest their dividends from stocks, this would be along the same line of thinking.
4. Again, if yields on the bonds are not entirely satisfactory, perhaps splitting your investment between the bonds and short put positions in the stock will help you meet your goals. For example, you could invest two-thirds of your funds in a bond and one-third in at-the-money or slightly out-of-the money short put positions with premiums of at least 10%. An example of this would be to buy Peabody's 6.50% coupon bond mentioned above and sell the January 19, 2013 $25 puts for $2.72 (10.88% premium for less than 10 months). If these puts expire out of the money and you do not sell any other puts, over the next twelve months, the return on your investment in Peabody would be just shy of 8% without ever having to own the stock at current levels.
If you are interested in purchasing any of the securities mentioned in this article but are nervous about counterparty risk wreaking havoc on your portfolio, learn how to hedge individual bonds in, "Protect Your Income Portfolio With Cross-Asset Hedging."
Please be aware that prices in the over-the-counter U.S. bond market may vary depending on the broker you use. I discuss this in my article, "Are You Paying Too Much For Your Bonds?" The current prices may also differ greatly from those listed at the time this article was written. For additional information on any of these notes, please contact your broker or read the indenture.
Also, please do your own due diligence on the financial profiles of the companies mentioned in this article. Only you can determine if taking the counterparty risk of purchasing individual bonds is suitable for you.
Disclosure: I am long BTU.
Additional disclosure: I am long CUSIPs 704549AH7, 02076XAC6, and 165167CG0.