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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35361  
Subject: Bond Defaults and Value Investing Date: 1/6/2007 3:25 PM
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Typically, the value offered to creditors by a Chapter 11 settlement –-“the workout”-- is less than the face value of the bond. And, typically, because the investor paid more for the bond than the workout value, a loss results. Thus, the word “bankruptcy” strikes fear into the hearts of bond investors who focus solely on “safe” income. But that fear can be unrealistic, because a loss isn't the necessary result. Sometimes, a Chapter 11 workout makes investors whole by returning full principal and all accrued interest. That's rare, but it does happen. Also, if the investor bought the bonds at less than par and par was returned by the workout, then not only was the investor been made whole, he also profited quite handsomely. Such a thing is also rare, but it does happen, as any value investor –-aka, someone who pursues total returns-- can report.

A more frequent result of the Chapter 11 process is the exchange of old debt for new debt, or the exchange of old debt for equity, or the exchange of old debt for a cash settlement, or various combinations of those alternatives whereby the bond holder does receive some value. If the value received is less than the value paid -–a classic case of “buying high and selling low”-- then a loss results. On the other hand, if the value paid is less than the value received –-classic instance of “buying low and selling high” -- then the transaction results in a gain. So the path to profits is simply that of getting the direction and the timing right and making sure a proper price is paid on entry and obtained on exit.

Such is currently happening with my positions in Federal Mogul's bonds, whose Chapter 11 court proceedings are ongoing. The company was in trouble in 2001 when I bought the bonds. The conventional wisdom at the time was the company would have to file Chapter 11 due to mounting lawsuits. Therefore, investors had fled the bonds, and prices had plummeted to the low 20's. But a review of the company's financials suggested that the company had more “intrinsic value” than they had financial troubles and the would be able to pay a portion offered some value. The question was “How much value would be offered to creditors?” and that was difficult to determine solely on the basis of the company's financial statements. But historical bankruptcy rates and typical workout values can be looked up. Therefore, the situation could be gamed.

If Federal Mogul followed “normal” patterns, they would be filing for bankruptcy shortly. (The mid-20's bond price alone argued that.) Furthermore, if Federal Mogul followed its industry's pattern of workout rates, $0.15-$0.20 cents on the dollar might be returned to creditors. However, because the bond market --through its pricing of the bonds-- was betting on $0.20, a slightly higher workout was likely. Not much higher, because markets do tend toward efficiency. But they also do typically err to the upside in optimism and to the downside in pessimism.

The situation with Federal Moguel was grim, but it was probably overstated. Therefore, $0.25 on the dollar was probably “fair value”. To buy at $0.20 cents would be buying at a discount, which is the first requirement of value investing: pay less than fair price. An estimated, average-low return on an entry at $0.20 might result a loss of $0.05. An estimated, average-high return might be a gain of $0.15. So, the direction of the trade was also obvious. A position that went long the bonds seemed to offer a classic, 3:1 ratio of reward to risk, just as shorting the stock would be the correct direction to trade the company's common.

What was unknowable was the timing of a long-side, debt investment. The company hadn't yet filed for Chapter 11 protection, and when they did, there would be no easy way to estimate the length of the wait, because Chapter 11 proceedings can drag on for years. When they did file, it might be possible to buy the bonds even cheaper. But it might not. However, there was a kicker that sweetened the trade. A 7.5% coupon on an entry at 20 would result in a 35% current yield. So a value investor would be paid quite well while he waited for them to default, so well in fact, that the longer the company delayed filing, the less exposure an investor would have for having recaptured his capital. So making an entry now, rather than latter, made sense.

The next variable a value investor -–or any investor -- has to consider is position size. What gets investors into trouble isn't the various risks themselves according to their types, but the quantities of the risks that are accepted as a function of account size. By their size alone, some positions are imprudent, no matter their putative safety. Conversely, no matter the risks, there is always a position size which can be prudently accepted and should be accepted if reasonable profits are to be obtained from markets, on average and over the long haul. (That isn't conventional wisdom, but conventional wisdom is rarely wise.) Also, whether what is a prudent size is also a tradable size is another matter, and that will vary from market to market. Sometimes investors are excluded from participating in certain markets, because the customary minimum position size is greater than their account would prudently permit, no matter their skills to properly manage the position. More bonds were available than my account could manage. So I sized a position, did my entry (split between two accounts), and began my wait, all the while collecting a fat coupon.

Then the shoe fell, and the company filed for Chapter 11 protection. For a year or so, not much happened. The bonds would trade up a point or two and then down a point or two, but mostly going sidewards, which was encouraging. No news was good news, and Chapter 11 creates a virtual blackout on news. Some companies post reorg updates on their web sites, and there are specialized news services that track Chapter 11 proceedings. But such services are prohibitively expensive. A small investor is forced to assume that the interests of the big players in the Chapter 11 proceeding will be congruent with his own: the big creditors want return of their money, just as do the small creditors. So, no matter the subordinate ranking of their claims, at least some of the company's assets will be prorated to the small note holders because settlements are accepted by majority vote. The big players often have to see that the interests of the small players are protected so that their own will be implemented. That's not always the case. Sometimes, the big players take everything, and that is becoming more so in American courts, which are very inferior to those of Europe with respect to small creditors rights. But that's the broad outlines of the Chapter 11 process: the claims of all creditors are ranked and pro-rated. If the filing company is asset-rich, then the workout can be fat even for those at the bottom of the ladder.

By 2005, the bonds had climbed to mid-30's and were being actively quoted again. It had been a 4-year wait for me. My profits had been achieved according to plan, and now I was anxious to get out. The bonds would climb a bit and then fall back a bit, as the creditor committees skirmished with the company. So things weren't looking adverse, but they weren't looking assured, either. I had a profit on paper. Maybe it was time to lock in that profit by selling.

I like to think that I'm a disciplined investor who takes to heart the adage: “Cut your losses, and let your profits run”. But I'm not. I'm as panicky as the next guy when my money is at risk. So I wrote an order to liquidate half my position, which was a compromise strategy: take some money off the table and let the rest ride. Shortly, I got back a message: “Order rejected. Size does not meet minimum”. I was annoyed. I had written the order as a market order. It should have executed immediately. That's what market orders are for: to get an immediate execution at the prevailing price. That's also the function of a market marker: to buy when no one else will step forward and to sell when no one else will step forward. I have never had a problem getting a stock trade done, no matter its size, if I used a market order. But the bond market is different than the stock market, and bond market makers do as they please, no matter their SEC-mandated obligations. In this instance, they weren't going to do the trade for less than 25 bonds. I was offering 8, and they were scoffing at me by not even low-balling me. So I backed away, and it was the best trade I never did do.

In all, I own 18 of the bonds, split 8 and 10 between two accounts, which is a modest position. My entry on the 8 was at 20.292 in 2001. The 10 was done at a comparable price, and both are now trading high 70's for a 284% gain on the former and whatever it is on the latter. Communications sent to the creditors suggest that next month should see a settlement achieved. So my paper profits might yet become real ones. My holding period so far is roughly five and half years, or an annualized return of 27%, which is fairly characteristic of value investments, though not of typical bond investments, which is the reason why the former term needs to be emphasized. Whether the underlying security is a stock or a bond doesn't matter as much as several broader factors, which can be summarized as follows: PRICING, SIZING, DIRECTION, TIMING, and PATIENCE. Those are the factors that matter. If a value investor –-someone whose concern is total returns-- can get those factors right, on average and over the long haul, then reasonable gains can be obtained.

CAUTION: If you think a value approach to bond investing might be interesting to explore, make sure you do proper due diligence before putting significant sums of money to work. The profits are real, but so also are the losses.

Charlie
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