When Cheap Bonds Look Attractive

Henny Sender gets a little bit ahead of herself in the WSJ today, although she does pick up on something important: that as the price of debt falls, it's starting to become more attractive, on a relative-value basis, than equity.

The news is that hedge funds and private-equity shops are getting very enticed by the high yields offered on discounted bonds.

Three weeks ago, with investors increasingly spooked, the banks that arranged financing for private-equity giant Kohlberg Kravis Roberts & Co.'s buyout of Goodlettsville, Tenn.-based retailer Dollar General agreed to sell some of that debt for as little as 87 cents on each dollar owed. Hedge funds led by TPG-Axon, an affiliate of TPG, swooped in, attracted by returns of close to 18%.
Indeed, that could turn out to be a better return than what KKR earns as Dollar General's new owner, with far less risk, given how much KKR paid to buy the dollar-store chain.

Of course, TPG hasn't made any returns at all, yet. Yields are not returns, and the value of Dollar General's bonds can go down as well as up. It definitely seems fair to say, however, that those bonds are less risky than KKR's equity in the company – and that there's a good chance that at these levels they will prove more lucrative, too. After all, if the bonds rise in price, you get a nice capital gain on top of your big coupon payments.

Sender also sees more value in default than I do:

If the company encounters even stronger head winds and one day defaults, the debt holders would wind up owning the firm...
The private-equity firms say that even if their companies have a lot of debt, these companies are far larger and stronger than in the past and have such flexible capital that they can withstand any storm. If they are wrong, of course, debt today that trades at 87 cents on the dollar will obviously fall much further.
But with current yields above 15% and the possible upside of debt turning to equity, private-equity firms are increasingly embracing these trades.

When Sender talks about "the possible upside" of converting debt to equity in default, does she mean that the value of the equity, post-default, could be higher than the 80 or 90 cents now being paid for the debt? That seems most improbable to me. There are distressed-debt trades which are designed to profit from converting debt to equity, but they don't have entry points at these sort of levels. Normally, that trade only works when you buy the debt at truly distressed levels in the mid-30s or so.