Tuesday, June 15, 2010 1 comments ++[ CLICK TO COMMENT ]++

BP's Bonds

The Gulf of Mexico oil spill has caused distress in various assets and I have been researching them lately. BP shares are the most obvious opportunity but other affected parties, including oil service companies and drilling companies that operate in the area, are worth considering as well. Companies involved in the disaster, such as Transocean and Halliburton, are worth researching. The ideal securities to own are convertible bonds and I see that Transocean has some convertible bonds.

One thing that makes this whole affair a bit risky is the oil price. People like me are bearish on oil and think oil is more likely to trade at $40 (or even lower) in the long-run than $140. You can make the right call and still end up losing money if the market marks down oil & gas companies because the expected long-term oil price declines (the mostly likely catalyst for such a re-valuation would a slowdown in China, which changes the long-term growth expectations.)

Bonds You Say?

In any case, one way to avoid the oil price risk is to invest in bonds. You introduce a whole set of new risks—inflation/interest rate being the big ones—but at least you are not exposed to the oil price risk directly. If you believe the company is likely to remain a going concern, then the bonds will provide a fixed return regardless of whether the valuation of the company goes down or not. I will note that a big decline in oil prices will weaken the cash flow of the company but given how these companies are paying out big dividends, there is a cushion for the bondholders.

I haven't talked much about bonds because the yields have been too low for my liking...until now, that is. Several of BP's bonds have hit yields of around 8%. It's still not that great, especially given how bonds are taxed at higher rates in most countries including Canada, but it's getting there. The upside is very small—the stock could rally 100% but you are looking at earning 8% with the bond—but the risk of capital losses is remote if you solvency analysis turns out to be correct. In contrast, you could lose a fortune with the common shares, not to mention being stuck with them in a possible bear market.

Something to Keep in Mind

Before I say anything more, I should note that there are very valid reasons why BP's bonds have sold off. One shouldn't assume that this is a temporary sell-off, with the prices bouncing back to what they were in a few months.

BP's credit risk is definitely rising. Fitch, in fact, downgraded BP by 4 notches today to BBB from AA. I don't have access to their opinion and I don't necessarily agree with them all the time, but there must be valid reasons for them to chop the rating down so much. Rating agencies don't raise their ratings very easily so Fitch must be seeing some material problems. So, you have to be prepared to hold the bonds to maturity. I haven't looked to see how illiquid any of these bonds are so you may be stuck with due to liquidity as well.

Quick Look at BP Bonds

Without reading the prospectus for the bond, which isn't how you should be analyzing anything ;) , here is one bond worth investigating:

I just picked out some high yielding ones and can't say this bond is the best one or how it fits within the capital structure of the company. A quick look does provide some rough idea of the environment.

The bond shown above is the 3.125% BP Capital Markets bond that matures in 2012. As you can see from the chart, the yield has skyrocketed in the last few months. It is presently yielding 8.699% and is trading at a price of $91.224. It's not clear to me if the yield includes the capital gains or not; let's assume this is the yield-to-maturity for now.

Is this above or below bonds of similar rating? Ratings don't necessarily equate to risk but they do provide some guidance. According to WSJ Market Data Center, the Barclays BBB corporate bond index is yielding around 5.020%. So, if Fitch is correct in its assessment, you are getting paid more for owning a BBB-rated bond from BP versus another BBB-rated bond.

Obviously BP is facing catastrophic losses whereas not all of the other BBB-rated companies are, so there is a reason the market is pricing it this way. But if you can do your analysis and come to the conclusion that BP will remain a going concern (or at least at a minimum, the subsidiary that issued this bond will remain a going concern,) the bond is attractive. In fact, unlike many BBB-rated companies, BP has enormous earnings power. I think the risk isn't financial in nature; instead, it is political. If the US government shuts down BP's operations or makes life difficult (such as by not renewing licenses, or allowing them to bid on leases, or buy/sell assets to other oil & gas companies,) then the investment questionable.

You are not going to get rich off this but it is a pretty solid return that is not correlated with the economy or the broad stock market. As long as your solvency analysis of the company is right (and your view of inflation/interest-rate/etc is correct,) this is a pretty decent return in my opinion. You are also only locking in your money for a little less than two years (with this example) so you are not that vulnerable to adverse interest rate changes or the onset of high inflation.

Short-term Bonds vs Long-term Bonds

I haven't given it much thought but if you do decide to invest in BP (or Transocean or some other) bond, you need to figure out if you want to invest in the short-end of the curve or the long-end. The excellent blog run by "Hunter" (I assume it's an alias,) Distressed Debt Investing, recently described the term structure of BP bond*. I am reproducing the chart provided below:

You should read the blog entry that I referenced above for more details but basically, the chart above shows the CDS curve at various maturities. The higher the number, the higher the CDS (or cost to insure) or the higher the yield (or the opportunity cost/"risk".) The yellow line is apparently how the curve looked last year, while the red is the present curve.

What you will notice is that BP is perceived as being more risky over the next few years than over the next 5 to 10 years. This sort of makes sense. After all, the oil spill mess is a short-term thing. In 5 years, no one will be talking about it and there would be some resolution of some sort. BP's survival will be determined within the next few years.

Now, back to the original question: is it better to buy the longer-dated bonds or the shorter ones?

This is a bond newbie talking so keep it firmly in mind... I think if you are a trader, I think the answer may be obvious (I'm not a trader though); but if you are a long-term investor, the answer is very confusing. If you are a trader and are bullish on BP, you probably should go for the short-term bonds. If you are bullish, your opinion is that BP will survive. If so, the biggest mismatch, at least based on the term structure, seems to be on the short-duration bonds.

If you are a long-term investor, I'm not sure what the answer is. I was thinking about this problem when I was contemplating the Sears Roebuck bonds an year ago. On the one hand, you want to lock in the attractive long-term returns for as long as you can. Imagine owning a bond that yields around, say, 10% from one of the top oil & gas supermajors for the next 20 years. I mean, if BP survives this mess, it's probably safer than most governments out there—including my own province of Ontario :(. But on the other hand, locking in money for the long-term makes you more vulnerable to macro risks. Imagine if inflation rises or governments increase the tax rate on interest income from bonds. Common shares at least have the possibility of raising dividends in line with inflation—although this didn't seem to have happened in the 70's and my guess is that most companies have no pricing power in highly inflationary periods—but bonds only pay a fixed income.

Sorry to dissapoint but I really don't have an answer on whether one should be targetting long-term bonds or short-term ones in situations like these. Distressed Debt Investing suggested buying the lowest priced bond since similar bonds of different maturities are treated the same in bankruptcy. But if the short-maturity bonds have a lower price, you may very well be missing out on the opportunity to lock in attractive yields for the long run. Perhaps what really matters is the attractiveness of the underlying business. If one didn't like the business so much—an example would be the Pulte Homes bonds (a homebuilder) I was tracking once—then buying the lowest price bond with possibly a short maturity may be the right thing. But if it were an attractive—I think companies like BP are attractive in the long-run if they are solvent—then going for the long-run may be a better strategy. I'm not sure; I'm all confused.

In any case, I think BP bonds at 8% is still not quite the sweet spot. Locking them up for the long-run will leave you vulnerable to macro risks like inflation. But if yields hit, say, 10% or 11%, it's worth considering.

BP-Backed Municipal Bonds

While we are on the topic of BP's bonds, you may also want to check out municipal bonds backed by BP. Bloomberg has a story that details how such bonds have been sold off, and are yielding around 10%, because of the risk:

Interest rates on some floating-rate municipal bonds guaranteed by BP Plc have surged to as much as 10 percent on concern that the costs of cleaning up the Gulf of Mexico oil spill and litigation are spiraling higher.

Yields on short-term bonds backed by London-based BP to build sewage and solid-waste disposal facilities at a chemical plant in Will County, Illinois, and a refinery in Texas City, Texas, that are now at 10 percent were as low as 0.5 percent at the beginning of the month. BP backs more than $3.5 billion of U.S. municipal obligations, according to Bloomberg data.

I don't have much to say here. I'm not too familiar with these bonds and muni bonds generally aren't that attractive to foreign investors (it's more attractive to Americans because they don't pay taxes on some of them.)

Side Note:
* I'm not sure if the term structure of a bond and the credit curve are the same thing; not sure if I'm misusing language here. Someone correct me if they are different things.

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1 Response to BP's Bonds

June 16, 2010 at 2:26 AM

健康的身體是事業成功的基礎。 ............................................................

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