The Peabody Coal Partially Hedged Bond Trade
I have written before about our success buying the heavily discounted bonds of certain distressed companies (Cliff's Resources, Allied Nevada, etc.) and concurrently buying put leaps on the same company’s shares. See the Cliff's Hedged Bond Trade
I have likened this trade to the act of buying an insurance policy on an asset that you own. In buying this insurance you pay a premium in the form of the cost to purchase a number of put contracts (right to sell the stock at a predetermined price for a specific timeframe) and this premium paid becomes part of the cost of your investment.
Interestingly enough, one of the best outcomes from these trades can be if the Company subsequently fails and the shares of the Company go to zero or near zero making the insurance contract very valuable. In a reorganization process, the bonds are senior to the shares and will almost always enjoy a better outcome than the shares. That differential is our profit.
In the case of Peabody, we felt that their financial wherewithal was such that they would not need to file for bankruptcy protection and therefore we only hedged our bond position by 55% - and this as it turns out was a mistake.
Due to the very low prices for coal, and a heavy debt load Peabody was eventually forced to file for bankruptcy protection. We made a significant amount of money on our puts (our insurance) but not enough to cover the loss on our entire bond position (only 55% hedged).
However, I also noted that holding the same class of bonds as ourselves were some very aggressive U.S. distressed hedge fund types and so I decided to hold the bonds and ride their coattails. See bondholders dispute
Fast forward several months and bonds which were trading as low as 5 cents on the dollar are now trading for approximately 37 cents on the dollar and our losing position has turned into an overall 30% profit (the second best return of our hedged bond transactions to date). Now it is still only a paper profit at this point and there are still things that can go wrong in the outcome of the reorganization of the Company a