Playing the Bonds vs. Equity Game in a Volatile Industry

An in-depth review of a cross cap stack trade idea

In this post, I discuss a publicly-traded company with distressed corporate baby bonds (i.e., bonds issued in small denominations that are primarily held by retail investors). These bonds are registered and can be purchased in most retail brokerages.

What I find interesting about the situation is that the company recently restructured its balance sheet as well as changed its business model to take on less market risk. I do not think investors are fully appreciating the reduction in bankruptcy risk as a result of these changes. Moreover, underlying industry conditions have improved materially since then which I believe increases the company’s chances of survival.

Admittedly, the firm continues to face liquidity challenges, has near-term debt maturities, and operates in a volatile industry. To bridge this liquidity shortfall, I expect the company to issue new equity, a tactic it has heavily relied on historically. Should the company get through this challenging period and address its near-term debt maturities, I think the bonds should rally materially. As an extreme example, the company’s bonds can 3x+ if they are repaid at par.

Given this dynamic, I think a cross capital structure pair trade here makes the most sense — that is, going long the bonds and short the equity. I think this opportunity exists because this is a small cap issuer (both equity and bonds < $200mm) in an unloved sector that is primarily held by retail investors.