The capital structure of a business implies that equity investors -- the owners of the business -- stand to benefit the most from a company's operating performance. Hence, equity owners have the last claim on a company's assets. Bond, or debt, investors have a higher claim but they have no ownership stake in the company. For the additional security, they receive a fixed return.
The energy sector, in my view, has temporarily suspended these laws of capital structure. In some businesses today, bonds are offering equity-like returns with the added layer of security.
Two months ago, I wrote about the high-yield debt of Comstock Resources (CRK). At the time, the bonds were trading for 13 cents on the dollar and my thesis was simply fundamental mathematics:
The annual coupon of $77.50 is paid semiannually ... so at current prices you'll recoup nearly 100% of your investment after just three coupon payments (i.e., over 18 months). Of course, that assumes CRK doesn't default. If it doesn't, each coupon payment after that will represent nearly a 30% return on your initial investment, or a 60% return per year. And the "jackpot scenario" would be for Comstock to pay back 100% of principal in April 2019. In that case, you'll collect more than $200 in interest, plus $1,000 in principal -- or $1,200 in total on a $130 three-year investment (an 823% cumulative return).
Buying the bonds at 13 cents was not a bet on seeing them go back to par. Instead, the bet was understanding the quality of management, the actions they were taking, and then evaluating if the company would be able to continue supporting these bonds under a strained commodity price environment. Also, it was a bet that the market had severely overreacted and that a simple reversion to the mean would have a positive effect on the price.
Today, these bonds trade for approximately 30 cents on the dollar. They have appreciated by 150% in two months plus a semiannual coupon payment equal to $38.75 was made. If you bought the bond for $130 (13% of the $1,000 face value), the coupon payment alone recouped 30% of your purchase price.
Another high-yield bond that is worth a closer look are the EXCO Resources (XCO) September 2018 7.5% unsecured notes (CUSIP #269279AD7). They are trading for 27 cents on dollar with a yield to maturity of over 80%. Same thesis applies here as to the Comstock bonds. Earlier this week, EXCO announced some specific measures to preserve the company's liquidity and reduce costs in preserving shareholder value. Implicit in shareholder value preservation is the continued good standing of the bonds.
High-yield bonds are not without significant risk. But it is my view that a careful and surgical selection of certain high-yield energy fixed debt offers a unique mispricing that will give investors better than equity-like returns from a more secured capital structure position.