Tuesday, March 8, 2016

Being punished for doing the obvious: Peabody Energy Corp edition

It is no secret that US coal companies are financially stretched.

But Peabody Energy is particularly stretched.

Here - courtesy Thomson Reuters - is a price chart for the 6% coupon Peabody debt due November 2018. Its a large issue with almost 2 billion at face value outstanding.

The price is 3. That is 3 cents in the dollar.

The yield to maturity is 266 percent.

If Peabody survives without a restructure this piece of debt will make you over thirty times your money.

Obviously the debt market thinks that Peabody is dead. Dead parrot dead.

Go tell that to the equity market.

This is Peabody stock yesterday courtesy Yahoo Finance.

Yes the stock was up 40 percent.

And if the company survives it is vanishingly unlikely to be a thirty bagger.

So it is kind of obvious that you should be long the debt, short the equity. It is very hard to construct a scenario where you lose.

Except that it was darn obvious 100 percent ago in the trade.

So here is what happened. Some wise-cracking hedge fund put on the trade, long the debt, short the equity. Can't lose except that they did lose.

They are getting smashed.

The debt has come down rapidly from 25 to 3 wiping out the long side of that transaction. The equity has doubled.

And our hapless manager - having been perfectly rational - is left nursing some sore losses.


A general comment

This is happening all over the energy complex at the moment. Debt and equity markets disagree and the disagreement has got wider and wider.

There will be some very bruised arbitrage managers this week.

Very bruised indeed.


PS. Disclosure in order. We have a few of these trades on in tiny size. We are down low-single-digits this month. We are not enjoying it. But we are enjoying it far more than the soon-to-be-out-of-work manager who decided to put the Peabody trade on.



Anonymous said...

Feel sorry for the manager, but surely, this just means a better entry? That said, I'm really wondering how come that the guys who hold the debt right now didn't hedge it by shorting equities. Unless, of course, the debt is predominantly held by the passive investors sold a JNK or something similar.

nemo said...

an apparent good trade gone bad. But I think at least one leg was foolish. Shorting equities trading in the price to book range of 0.05x to 0.1x is not very smart. Relative value probably lose meaning in that range.

James Dollinger-McElligott said...

At this point the equity is really just a way out of the money call on the underlying asset value. As a call option there are three things that could add value:
1) Increase in implied volatility of the underlying assets
2) reduction of the strike price
3) Increased time value

I don't know what Peabody's cap stack and maturity profile look like but if I had to guess at an alternative explanation to pain trade I would go w/ number 3

Anonymous said...

the guy shorted an insane amount of calls in the stocks...except he got assigned when they started going up. he had no borrow, and the gamma exploded in his face!

Anonymous said...

Short squeeze on the stock, thats all, nothing to do with fundamental value.
Its happening all over the place at the moment.

Your sentiment is 100% on track though, the stock was trading out of line with the bonds.

The trade is not really a possible 30 bagger .
The ask was $4 as per your screen, as this is a US bond that price is 'clean'.
Thus as of today there is 116 days @ 6% accrued to be paid on the coupon by the buyer, thats about $1.92 ish

So cash price is 5.92, and thus its a bit over a 17 bagger.

Still a better risk adjusted bet than the stock.


Fameron + Fitch said...
This comment has been removed by the author.
Nirav Kanodra said...

Equity = call option on Firm Value
Debt = put option on Firm Value.

This strategy you are short volatility.
Not the best bet when volatility of underlying (oil prices) is so high.

The Bankster said...

Having once traded distressed bonds (BTU even) and done some cap arb, I'd say the short equity side of the trade made little sense at the time. Equity of even bankrupt companies often trades wth 10s of millions of nuisance market cap. Recovery in bankruptcy is rarely zero, whatever you were taught about prior of payment.

Mihran Tossounian said...

A better trade would have been to short the stock and buy 2018 calls. They were selling for almost no premium.

Sean DiTullio said...

No expert on this but I went to check the market cap. It was $40 million and now its 100 million. Why would you even both to short the equity? Agree its a call option. It seems far too risky to ever short a stock at that level as a hedge. And I don't think the market offered liquidity for it. I mean I can personally cause Peabody stock price to double at that market cap.

Anonymous said...

the borrow rate on Interactive Brokers for BTU has been close to 100% for some time now... and short interest, well, i think you get the picture....my guess is that far more than just the small float is sold short...everyone knows the SEC is impotent in regulating any of that.... look at the move in ACIIQ last august when it went from 1 to 10 in a month before declaring bankruptcy a few months later...if all the shorts were actually forced to buy into this thing and the longs held steady there's no telling where this thing could go....if the rules were actually enforced that is....

as for similar moves in the equity markets this week...the trade has been simple...disregard everything but short interest and buy accordingly.....

Art said...

Or just buy some $8 strike call options like I did when they were just 0.06. 20x return to date on the short squeeze. If the company survives and goes back to even a fraction of its market cap 5 years ago, it's still a 1000x return at least. That's the kind of odds I like :-)

Anonymous said...

i'm in the distressed world.. and indeed longing bonds and shorting equities is many times foolish (even though theoretically sound perhaps).

many a time, equity is just an out of the money option any any restructuring outcome

put it anther way, if they restructure the debt to some sensible proposal - it is no inconceivable that equity rallies

in asia, its even better, you short the debt and long the equity! sponsor steals from bondholders to give to equity :)

Anonymous said...

one last thing, if you're just starting to short a stock at 2 that was at 1000 (taking into account splits) just 5 years ago well then:

a) you're a complete horse's ass when it comes to risk management


b) lord i hope you have billions of AUM because you're the kind of moronic jackwad that creates the kind of dislocations in the market that patient risk/reward investors/traders drool over...

Azabu Traveler said...

"Obvious"? Only in so far as it is an obvious rookie mistake for those newbies to capital structure arbitrage. Nirav is absolutely correct: you are short a way in-the-money put option on the "enterprise value" (by owning the distressed bonds), and short a way out-of-the money call option on the "enterprise value" (by shorting the stocks).

Being short volatility is inherently dangerous in this sector.

But, if the enterprise value moves up, the out-of-the-money options will show far greater price sensitivity (delta) than the in-the-money options. In other words, you will lose more money on your call position than make on your put position.

Even worse, if the enterprise value falls, but the volatility rises at the same time, you will lose money on BOTH sides (vega and delta).

This outcome isn't necessarily a market inefficiency, because the options markets SHOULD behave this way. Sounds like the fund managers were making a bet they didn't really understand.

Anonymous said...

I was fortunate to be one of the Call owners. $60mm mkt cap Lots of short interest, potential for restructuring where equity might get something. Anything can happen w a $60mm market cap company especially one that was much higher before and tons of debt. Oh and the options were stupidly cheap..

Now i dont advocate buying the stock or even buying the calls but shorting it.. it was a no brainer NOT to short.. I have seen this movie way to many times before.

Anonymous said...

Someone correct me if my thinking is off here, but at these levels why would you not just go long the bond? Scenario 1) Nothing happens, bond gets repaid at face value. Congrats you are a genius. Scenario 2) Company goes bankrupt. This is where you have to do your work and find out what the company is worth. However it seems unlikely that you would not at least get your money money back at these prices. Or is the bond unsecured? Scenario 3) Company does not go bankrupt, however the debt needs restructuring and bond holders take a haircut. How big a haircut >97% of face value? Again unlikely to at least not get your money back, as to big a haircut and the bondholders just put the company into bankruptcy and take their chances? And we are back at option 2. Best bit is you have a definitive time frame for the trade to play out. Position size accordingly. Leave the equity alone. What am I missing?

Anonymous said...

The bonds are unsecured and worthless.

The 1L is trading in the high 30's.

Anonymous said...

I am late to this particular party, but as a distressed debt guy with some quant chops the comparison in the original post is a bit misleading.

Both the unsecured debt due 2018 (and all the other unsecured debt) AND the equity are out of the money call options on firm value. As previously mentioned, the 1L is at about 30 and is the only in the money instrument in the capital structure.

If you look at the full capital stack, the total unsecured debt balance is $3,758, so even at 3 cents the market cap of the unsecured debt stack is $112mm-ish. The market cap of the equity is around $70mm. The market is valuing the debt at $42mm more.

I'm not totally sure what hedge ratio you would use for the trade (1:1 in value is probably close-ish?), but it's not that clearly compelling to me. If I were to do something like this it would probably be long the 1L (which won't get zeroed out) and short the equity/jr. debt with a lower delta. I don't find that position hugely compelling, but it is better (and would have been down less) than the one in the original post.

Jason DaCruz said...

Hopefully you didn't close out?

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