Higher risk strategies for greater returns
The speculative strategies with bonds are generally only suited to experienced investors who can manage the higher risks involved. This is no different to speculating with stocks. These speculative bond strategies are popular with hedge funds and experienced investors.
Convertible Bond Hedge
The convertible bond hedge strategy was a popular tactic which the famous investor Benjamin Graham used. Benjamin called this strategy ‘related hedges’.
The strategy is quite simple and combines the convertible bond strategy with a hedge. This involves buying a corporate bond which has the option to convert into stock and simultaneously short selling the stock (which is from the same company as the convertible bond).
Example 1: AMAG Pharmaceuticals NASDAQ:AMAG convertible bond with 2.5% coupon rate, 2019 maturity and a strike price of $27.09 for conversation into stock. The current stock price is $18.50 (May 19, 2017). Stock does not pay dividends.
Example 2: Avid Technology NASDAQ:AVID convertible bond with 2% yield, 2020 maturity and a strike price of $21.94 for conversation into stock. The current stock price is $5.25 (May 19, 2017). Stock does not pay dividends.
The strategy profits when the stock price falls and as such is a strategy which is best suited to bearish market conditions – especially bear markets. The Dow Theory is a useful indicator to determine the state of the market.
When the stock prices falls, it usually falls more than the bond price falls, especially when the stock price declines significantly. The strategy works well with overvalued stocks that are fundamentally sound.
Since the strategy involves short selling the stock, the short interest fee needs to be considered as well as the dividends. The strategy works best with low short interest fee stocks that pay little or no dividend – since the investor has to pay any dividend due with shorting the stock. Also the Bid-Ask spread for the convertible bond needs to be within reason (the lower the better). Large bond spreads can quickly turn a profitable trade into a losing trade.
Should the stock price fall sufficiently more than the bond price, the stock position is bought to cover the short stock and the convertible bond is sold. The profit is the difference between the short sale profit and the bond capital loss. From this profit any dividends paid are deducted and the short interest fee is deducted and any interest earned on the short sale proceeds is added and the coupon payments are added.
Should the stock price rise above the convertible price, then the bond is converted to common stock which covers the short sale and thus exits the trade. The loss is the difference between the short sale price and the convertible price. From this loss any dividends paid are added and the short interest fee is added and any interest earned on the short sale proceeds is subtracted and the coupon payments are subtracted.
Convertible bonds can have their strike prices well above the current stock price. As the above two examples show, the difference can be significant (especially with example 2).
The maximum loss is reduced when the short sold stock price is closer to the convertible bond strike price. Should the stock price essentially trade sideways, then the investor ends up holding the short stock and the convertible bond and the holding costs need to be considered. While the investor receives the coupon payments and any interest due on the short sale proceeds, the investor pays the short sell interest fee and any dividends due. The net result might be a positive figure meaning that the investor still profits from holding the position, but if the net result is negative then the position ends up costing money to keep the position and investors might consider a time limit after which the position is exited.
Bankruptcy Bond Tactics
Buying corporate bonds of large companies in or close to bankruptcy was a common hedge fund strategy used by Benjamin Graham.
This is a very high risk strategy which can earn some nice capital gains for experienced investors and can also easily lose their entire invested capital.
The most common bankruptcy bonds are speculative grade corporate bonds with smaller companies and these are the highest risks. The risk reduces with larger companies as they have a higher probability in recovering from their financial woes.
Sometimes municipalities end up in bankruptcy and buying municipal bonds is a lower risk compared to corporate bonds as the recover rate is relatively high, since the bondholders are usually the only creditors.
The bonds of companies facing bankruptcy often trade for a fraction of their face value, however very few bankruptcy bonds will ever see the bond value return to its face value if reorganization was sufficiently successful. If the company is liquidated, then the recovery (the amount returned to bondholders) can range from zero up to around halve of the bonds face value. In other words, bondholders rarely see the face value amount returned.
To profit from buying bankrupt bonds requires buying a bond at a sufficient discount to what the investor thinks they will receive back once the bankruptcy process is completed. This is where the difficulty comes in – how much will be returned.
Some general guidelines are that companies with high intangible assets relative to their tangible assets are undesirable. This is because in bankruptcy especially liquidation, the only thing that has any value are items which can be sold at auction. Companies with a high portion of hard assets, especially real estate are desirable. Land is particularly good as these are normally recorded on the balance sheet statement at cost and are not adjusted to reflect any increase in land value.
Any investor considering buying bankruptcy bonds needs to be clear that there is a good chance that the entire amount paid will be lost, as there are plenty of bankruptcy cases where bondholders receive little or no recovery.
The strategy has the best chance for success when bonds are bought at sufficiently depressed prices with large companies that have balance sheets loaded with hard assets and moderate intangible assets. The maximum loss is limited to the amount paid for the bond and the realistic maximum recovery is around half the face value. Thus the profitability of the strategy is based largely on the price paid for the bond – the lower the better.