13.5% bonds decent?

[Fermion]

In my trading account I made a play that I think has worked out so far.

I have been tracking some mining stocks who financed big builds with high interest rate loans. On one of these I bought the bonds about a year after they were on the market at 96.7% of par (12.5% bonds, so paying me 13.5%). I also bought puts on the companies stock in the theory that these loan shark type bonds would put a hurt on the stock price.

Sure enough, the interest is killing the poor company and they are just making enough profit to handle the bonds and pay the executives nice yearly bonuses. The stock price has fallen 50% and the puts I bought I sold for 100% profit.

This leaves me holding these 2019 12.5% paying bonds. They are trading at 97% of par right now and are callable with prepayment penalty in Dec 2016 (callable at 106.5).

This was mostly an experiment, and I guess it was a success as I made more money on the puts than my initial bond investment. I am not sure if I should cash in the bonds or just hold them. 12.5% is a pretty decent yield and I like the money flowing in.

I am considering trying this again if I can find another company with high yield junk bonds and a high stock price. Perhaps there are opportunities in the oil industry coming up.

I wonder where this blows up? Bond defaults while company stock remains high priced and puts expire worthless?

 

[ERD50]

I guess the 'catch' I'm seeing, is that over the long run, the cost of buying puts will really cut into that 12.5% interest.

It worked for you because of the puts, but what if that stock price just plodded along? How much do the puts run per year? How close to the stock price are the puts?

Interesting concept though - I'm just not sure it will work on average.

-ERD50

 

[MooreBonds]

Sure enough, the interest is killing the poor company and they are just making enough profit to handle the bonds and pay the executives nice yearly bonuses. The stock price has fallen 50% and the puts I bought I sold for 100% profit.

This leaves me holding these 2019 12.5% paying bonds. They are trading at 97% of par right now and are callable with prepayment penalty in Dec 2016 (callable at 106.5).

This was mostly an experiment, and I guess it was a success as I made more money on the puts than my initial bond investment. I am not sure if I should cash in the bonds or just hold them. 12.5% is a pretty decent yield and I like the money flowing in.

it depends on the company's cash flow, as well as what their past and future hedging looks like. Have they been selling most production at spot, or did they have a lot of production hedged so far? If the later, then they may not have much production hedged for the next few years, and might have a drop in cash flow due to the lack of hedging.

Look at their most recent quarterly/past2 quarters and their hedging profile. If they had decent cash flow that could handle interest payments and some debt repayment in a few years, I'd take a chance. Also depends on their primary commodity mix. If mostly iron, iron should be rebounding at least somewhat over the next 2-3 years. Possibly the same with coal, but just depends on specific minerals/resources they mainly deal with.

 

[FIRE'd@51]

I wonder where this blows up? Bond defaults while company stock remains high priced and puts expire worthless?

Seems very unlikely.

I agree with ERD50 that the "catch" is that the annual cost of holding puts is likely to greatly reduce your yield.

BTW, since you have already sold your puts at a profit, I would use this profit to reduce my basis in the bonds and recompute the yield based upon the new basis.

 

[Fermion]

I think to implement this will take quite a bit of searching. What I want to find is a bond paying X and a one year put costing Y where X - Y = 3% or higher. It was like that in the company I did this on but I am not sure if that was a rare lucky find or more common.

There was never a time where the bond price dropped more below par than the put price increased in value. It seems a lot of the time the share price will drop due to dilution yet the bond price will go up because the dilution added more cash and security to the long term prospects of the company.

Anyway, it is fun searching, and the risk seems somewhat low.