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This is going to go way off everyone please forgive me…. However, I think [the] example of the 5 to 10 cent on the dollar for recovery is low.


My sense is that a discussion of recovery-rates is NOT off-topic for this board. It’s a topic that Cohen and Malburg don’t get into in their book, for their concern being to help beginning bond-investors stay out such situations in the first place. But if one buys a lot of bonds, finding oneself in a Chapter 11 situation is going to happen, sooner or later. So it’s good to be aware of how things might play out. In other words, rather than fear defaults and assume the worst will happen (a zero recovery), why not look at historical patterns and then estimate how a specific issuer might be a part of those patterns, so that the present price of its bonds (and, therefore, their yield) can be better understood?

This is a story I’ve told before elsewhere, but it is relevant here. Shopko (formerly ShopKo until May 2007) is a chain of retail stores based in Ashwaubenon, Wisconsin, near Green Bay. With approximately 16,000 employees, the company has a presence in 13 states, and generates annual sales of approximately $2.2 billion. A lot of years back, I was looking for investment ideas, and I was reading one of the semi-annual reports from the Oakmark Fund managers, which is a value shop, to their shareholders. They were talking about their recent stock buys, and one of them was ShopKo, a company I had never heard of, for being a west-coaster.

They were running the company’s numbers, arguing as fund manager are inclined to do, that ShopKo was “increasing market share”, yadda, yadda, yadda. But one fact (for me) stood out above all others. ShopKo had few leasing agreements, because they typically owned the land on which their stores were sited. From a stock investor’s perspective, that’s an interesting fact, because it likely reduces the company’s overhead. But from a bond investor’s perspective, that land –-carried at book, according to GAAP rules— likely represented marketable and very under-valued assets if the company filed for Chapter 11 protection.

Bingo! I knew I had found an edge. The historical surveys of recovery-price by industry and seniority suggested something like the following could be expected for “General Merchandise Stores” (which seemed to be the category into which ShopKo best fit):

Senior Unsecured, 45.
Senior subordinated, 30
Subordinate, 29
Discount & zero-coupon, 10

“OK”, I thought. “Those numbers aren’t guaranteed. But they might establish a baseline.” My thinking was this. If ShopKo went down, I should expect to recover something of my purchase-price. But since they owned their land, and most general merchandisers didn’t, the recovery-rates might be even a bit more favorable. So I went searching for their bonds, and almost nothing was offered, which is almost always A Good Sign. If there is a lot of supply, there is a good reason, and it is generally because no one wants the bonds. If there is little supply, there is a generally a good reason, and it is because buyers aren’t selling. They know they have a good deal, and they are sitting on the bonds, intending to hold to maturity.

Three issues were offered in small quantities, odd-lots of 3-5 bonds each. So I took a deep breadth, conquered my fears, and bought everything I could get hold of.

-5 of their Senior 8.5% of ’02 (at a price of 84.799, for a YTM of 26.11%) that matured a year later.
-5 of their Senior 9’s of ’04 (at a price of 76.990, for a YTM of 17.68%) that also matured.
-3 of their Senior 9.25’s of ‘ 22 (at a price of 58.428 for a YTM of 16.28%), a position which I still hold and to which I added last December.

OK, now let’s review what was done. I bought 13 bonds in all, for an average-weighted price of roughly 75. My upside, should the bonds mature, would be par plus coupons. My downside, should the bonds fail immediately, might be the historical recovery-rate, or something in the neighborhood of 30 to 45. Just for the sake of simplifying the math (and to acknowledge role that the current market value of their land play in a workout), let’s guess a recovery-rate of 50.

So I could expect to make at least 25 points to the upside, and I could expect to lose at least 25 points to the downside, or a “break-even” deal with regard to a risk-reward ratio. That’s not the 3:1 win:loss ratio the stock guys prefer to work with. But those odds would need to be adjusted as to the likelihood of an adverse event happening, which can also be done by appealing to historical patterns of defaults by rating-notch. When that factor was considered, the odds seemed worth accepting.

Cohen and Malburg don’t do much buying below triple-BBB, and SkopKo’s bonds were rated spec-grade. But I would argue that is the same type of reasoning needed to make a success of investing in spec-grade bonds that is needed to make a success of investing in invest-grade bonds. So what if an investor recovers nominal-principal, because he/she hasn’t put it at risk, but he/she fails to preserve purchasing-power? Which actually, when all things are considered, is the riskier choice?

That’s not something I intend to argue one way or the other. I’ll let Cohen and Malburg speak for themselves and let readers take from their book what makes sense to them. But sooner or latter, a would-be bond-buyer is going to have to deal with the topic of default-rates and recovery-rates and make investment-policy decisions about how to deal with them, whether by avoidance or by management. I favor the latter, as apparently do you, whereas Cohen and Malburg seem to lean toward the former. They want to minimize trouble by staying as far away from it as they can, which is how Defensive Investors best do their investing. Enterprising Investors (in Graham's sense of the term) will go the extra step. But one can't decide which mode of investing one prefers or might best serve one's needs if certain topics are never considered. Hence, I'd argue that recovery-rates aren't "off-topic". They really are a needed part of the discussion of Cohen and Malburg's book.

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