Junk bonds: Not always junk, but pretty often (Callon Petroleum)

November 19, 2009

If you have been following this blog for some time, you may recall the first move I recommended was the bonds of Bon-Ton Department Stores, which I suggested could be hedged by shorting an equivalent dollar value of the stock. At the time the bonds were at 46 and the stock was at $4. Now, the company has announced that they are not as doomed as previously thought, so the bonds have shot up lately to around 90 and the stock to almost 12. The bonds have paid their semiannual coupon since then, so they have properly speaking shot up to 95, but the follower of this move would have made $500 on the bonds and lost $800 on the short. I think that $12 for a company that is still having all of its earnings eaten up by interest is too high of a price, so these results have not diminished my enthusiasm for capital structure arbitrage (which is the formal name for this move), or for junk bond investing. Ben Graham wrote that even an unattractive form of investment, like a bond that is inadequately secured, can be attractive at an attractive price. Even though they are unlikely to appreciate past par, especially because most bonds these days are callable, they can still produce attractive returns.

oil_platform_rig_hiberniaHowever, the majority of junk bonds are junk for a reason, and they require careful screening. Consider the bonds of Callon Petroleum Co., which pay 9.75% and are trading at 60, currently yielding 16%. They fall due in December of 2010, but most of those bonds will never be redeemed, because the firm was forced to institute a tender offer because what with two hurricanes and a drop in the price of oil they were forced to discontinue a large operation in the Gulf of Mexico. Their other operations are barely able to cover their interest. The terms of the tender offer are  replacing the $1000 9.75% bonds with $750 13% bonds (thus actually saving nothing on interest), plus what works out to 37 ½ shares of stock. The new bonds fall due in 2016. The company is pleased to report that they have over 90% participation in the tender offer.

However, there is a small problem with their plan. Although the company is presently able to cover their interest, and possibly even with a few pennies left over for the shareholders, the firm’s long term strategy is in doubt. Unlike Linn Energy or Breitburn Energy, which focus on properties with a long development life, most Gulf of Mexico properties have a development life of only a few years, with most of the production heavily front-weighted. So, they have to acquire, explore, and exploit properties with considerable frequency. However, with no spare income and also no shareholders’ equity left (even with the bonds discounted and the nonrecourse debt from the discontinued operation moved off the balance sheet, they are below even), it is hard to determine what the company will use to acquire these new properties. They claim to be looking into longer-lived properties and joint ventures, and best of luck to them. Otherwise, they are potentially doomed beyond the assistance even of the Chapter 11 that they are trying to prevent with this tender offer.

As is often the case in distressed debt, the decision of whether to tender the bonds is a prisoners’ dilemma situation; if enough bondholders accept the exchange, the company will be able to redeem the non-tendered bonds without difficulty, so the holders who rejected the tender offer will make a windfall. But if not enough holders accept the tender offer, the company will be forced into bankruptcy. This is why, as Moyer wrote in Distressed Debt Investing, firms tend to require over 90% participation in any tender offer, a provision they can waive if necessary. Here, there is legitimately over 90% participation, so that hurdle is not an issue. Based on the current prices, apart from about $90 (discounted) in coupon payments due between now and the payoff date, the bondholder who rejects the offer is looking at $900 (discounted) for a price of only $510 per bond. This implies that even now there is an expected 57% chance of no recovery, assuming that 60 is also a fair price for accepting the tender.

The tender offer expires on Monday, and it is clear from the overall prospects of the firm, that it would be best to reject the tender offer and take our chances with the 2010 payoff. However, this firm does not appear to be another Bon-Ton stores, so the wise fructivore should consider a purchase very carefully.

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