Security Analysis and Business Valuation on Wall Street,: A ... - lib

CHAPTER 25Distressed Securities<strong>and</strong> TurnaroundsMany novice investors wonder why companies with operating losses havepositive stock prices. Why do the bonds of some bankrupt companies havesubstantial value? In this chapter, we answer these questions by exploringturnarounds <strong>and</strong> bankrupt companies.Adistressed security doesn’t always belong to a bankrupt business. For highly leveragedcompanies, the continuation of operating problems prompts investors toanticipate debt service troubles, causing the bonds to sell off, their prices to decline,<strong>and</strong> their yields to increase. Thus, the nondefaulted bonds of troubled firms can yield5 to 10 percentage points higher than U.S. Treasury bonds having similar maturities.Depending on seniority, collateral, <strong>and</strong> other factors, defaulted debt may tradefrom pennies on the dollar to a high percentage of par value. Of course, investors indefaulted debt don’t count on being repaid at maturity. They’re hoping these fallenangels will be transformed into higher-value securities, once a workout or exchangeoffer is completed by the debtor.As the reader can surmise, the distressed bond sector is a subset of the largerjunk bond market. A junk bond is strictly defined as a bond that is rated lower thaninvestment-grade, the category encompassing only the top four rungs of the ratingagency ladder. Any bond falling into one of the lower rating levels is referred to asnon-investment-grade—a junk bond, in Street jargon. (See Exhibit 25.1.) Despite thederogatory nickname, many issues falling below investment-grade belong to healthycompanies, but the bonds have heightened risk when compared to their investmentgradecounterparts.Common shares falling into the distressed category belong to two kinds of firms:bankruptcies <strong>and</strong> turnaround c<strong>and</strong>idates. A shareholder of a bankrupt firm derivesvalue primarily from his ability to impede progress in the Chapter 11 proceedings.This value is primarily of the legal nuisance variety <strong>and</strong> has little to do with thefirm’s economics. For the purposes of this chapter, I will only discuss the shares ofcompanies that fit the second category, namely a turnaround business. A turnaroundis an established enterprise that experiences operating problems that appear to betemporary. After a year or two of subst<strong>and</strong>ard performance, investors anticipate thebusiness will return to normal.331