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Understanding the fulcrum

There is a danger in being too caught up with the numbers when analyzing the fundamentals of a company. A scenario-based thinking and preparation is vital when dealing with the edges of the capital structure, the edge where bond and equity meet. A stock with a lot of book value of assets covering its debt might suddenly become vulnerable if the assets are considered at a fire-sale valuation. A vision of adequate safety on paper might be a mirage.

Equity is what is left after the bondholders are paid off. Within the debt part, there may be different levels of bondholders, with or without collateral, and covenants might tie them together. The bonds one might buy in a steady state assumption would be different to those when bankruptcy is expected, since coupons are suspended during bankruptcy. Why would anyone buy a bankrupt company’s bonds? Quality assets seldom die; they are just repackaged. A highly levered company could come out of a Chapter 11 process with part of the old debt becoming new equity, with a reduced debt load – like a beautiful butterfly coming out of an ugly cocoon.

There is a bankruptcy plan that has to be agreed on by a judge. Anyone can propose it, but it gets voted on. The votes of the fulcrum security will matter the most: this is the class of bonds that is suffering partial repayment. It is the last
one to suffer impairment, and the most likely to be converted to equity. Typically, all classes below it are worthless, and all classes above it are made whole. Control the fulcrum and you control the future.

A new trend I expect in 2016 is the early filing route. A prepackaged bankruptcy plan, with the company choosing to go to the court well before its debtors drag them there for missing payments, hoping to better control its fate. There is still pain to come in energy and 2016 will not be for the faint of heart.

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