Bonds: Here's the Glory

There is a lot to be said about these instruments. They are 'safer' than equity no doubt, but do not offer the glory of equity returns (ok I admit that you have to look at more than a 10 year period). Distressed Debt investing however has its own charms, it offers 'lower' risk than equities but equity type returns. Looking at the quarterly filings by some of the gurus, there's one common element: distressed bonds.

I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)

Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.

Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.

In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.

Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.