How to calculate EV of this proposed investment?

[Bill C]

As part of my retirement portfolio, an advisor has suggested I purchase a "high yield" bond in a company that has some chance of going under during the 3 year term of the bond. Obviously he feels it is unlikely that it WILL fail, but admits there is perhaps a 10% chance the company will fail. The bond is yielding approximately 10%.

How do I calculate EV here, and how can I best understand the risks involved in terms of mathmatics?

Any help would be greatly appreciated.

bill c

[icetonez]

I think it is definately +EV and that's assuming you would get nothing from liquidation which I think is unlikey. I'm not sure, but I think you could just take for example a $100,000 investment and do this:

-100,000 * .10 v. $133,100 * .90

[DesertCat]

[ QUOTE ]
As part of my retirement portfolio, an advisor has suggested I purchase a "high yield" bond in a company that has some chance of going under during the 3 year term of the bond. Obviously he feels it is unlikely that it WILL fail, but admits there is perhaps a 10% chance the company will fail. The bond is yielding approximately 10%.

How do I calculate EV here, and how can I best understand the risks involved in terms of mathmatics?

Any help would be greatly appreciated.

bill c

[/ QUOTE ]

Your best EV may be to fire the advisor. If he's putting you into a risky investment that you don't seem to understand, that's a big -EV right there. It makes me wonder how much he is charging you, and how fair that is, and how safe the rest of your investments are.

If this is your retirement fund, and you are not a skilled investor, I can't see putting even a tiny portion of your portfolio into this bond. What's the benefit? The greater yield is miniscule if it's a tiny investment, and the risk is too high if it's a significant investment.

You can get a risk free yield of 4% or so right now from the federal government. Which means 100% of the time you get 4%. Your bond pays 10% 90% of the time, and if you believe your advisor, -100% the remainder. EV by that calculation is -1%, or about 5% less than a risk free deal.

Of course I'm simplfiying. you are getting 10% for a three year term, you probably have to take much less than 4% on a three year treasury (don't know, I'm equities only right now). And as the other poster said, if the company fails you still have a chance of getting some or all of your money back.

But you can't understand your risks in terms of raw mathematics. You need to review the companies SEC filings in detail to understand the amounts and nature of the assets that you are counting on to repay your bond. You need to understand your bonds position, i.e. is it getting paid first, or is it subordinate to a bunch of other bonds that get paid before it. This is very tricky stuff, which is why I am so dismissive of your advisor.

A key rule of gambling and investing is to stick to what you understand. When your advisor puts you in things you don't understand, then you will never be able to truly estimate your risks.

[DesertCat]

[ QUOTE ]
I'm not sure, but I think you could just take for example a $100,000 investment and do this:

-100,000 * .10 v. $133,100 * .90

[/ QUOTE ]

Both of our math was wrong . In your case bonds don't compound, and you won't have a 100k gain, that's just your basis. Where you were ahead of me is placing the default risk is over 3 years, not one year as I did it, which I believe is what the author meant. Teh formula should be like this

-100k*.1 + 30k*.9 = +17k, or 5.67% risk adjusted yield.

But I'm wondering if a 3.3% annual default rate isn't rather low for a junk bond. Once again, the only way to make a reasonable estimate of the bond's security is to review the company and the bond in detail.

[Bill C]

The bonds are GMAC; the company that "may fail" is General Motors.

I appreciate the helpful thoughts, and if anybody has more insights, bring them on!
FWIW I think this advisor is pretty good and has brought me to early retirement on his picks. Still, I wonder about this one...

Best to all...
bill c

[adios]

You need to provide a lot more info on the specifics of the bond.

[crazy canuck]

FWIW I think this advisor is pretty good and has brought me to early retirement on his picks. Still, I wonder about this one...

Or more likely that he is pretty lucky.

[Bill C]

Thanks Adios,
I'm not very knowledgable about bonds (surprise!). What information do you need? I'll see if I can get it.

bill c

[player24]

General Motors is not technically a "high yield" bond because it is still not rated below investment grade by any of the major credit rating agencies. But it is one notch from "high yield" and the market is expecting a downgrade to below investment grade.

Because of the company's enormous cash balance, there is materially less risk in short maturity GM debt than long maturity debt. Default risk in a three year window is low/moderate. Longer term, risk rises considerably.

GM 6.125% notes due 2008 are offered at 94.62 which translates to a yield of 8.34%. You will not get a 10% yield without moving further out the curve (i.e. longer maturities, much more default risk).

GM represents about 2% of the entire outstanding principal of investment grade bonds. If/when the next ratings downgrade occurs, some institutional investors will be forced to sell the bonds. The buyers will be high yield investors, including mutual funds, pension funds, insurance companies, hedge funds, etc... There is great concern in the market that selling pressure will continue to push the bonds lower in price. The bonds have been trading off steadily for the past few weeks and the selling has accelerated in recent days.

GM's cost structure is way out of line with current market share and the company's new vehicle lineup will probably result in even greater loss of market share. Labor costs are extremely high because of UAW contracts which grossly overpay workers and do not expire until 2007. GM is simply not competitive and the situation is likely to get worse before it gets better.

Never ever ever ever concentrate your financial assets in a single corporate bond, regardless of credit quality. Diversification is the only free lunch in investing, especially in corporate bond investing.

Long term historical default rates in the high yield market are about 5% and the range is 1% to 14% (default rate was only 1% in 2004). Keep in mind that default usually results in bankruptcy, but this does not mean you lose your entire investment. On average, defaulted corporate bonds recover about 40 cents on the dollar. The results are better for secured debt.

Probably more info than you need/want. I believe the risk and return on GM bonds are fairly well balanced at current prices, but I would never consider this investment except in the context of a well diversified portfolio.

[adios]

The "seniority" of the debt, if the bonds are "callable", agency ratings (I'm fairly certain the bond market is anticipating the rating agencies to downgrade a lot of the automakers debt so you probably need to do some research into what the ratings are anticipated to be ), Yield-to-maturity to name a few things. Once you have a good idea as to what the rating of the bonds will finally be, you might want to compare them to other bonds that have the same rating both in the corporate sector and the mortgage backed security (MBS) sector. I'd definitely study up on bonds a little bit before taking the plunge. You also might want to think about a bond fund that is appropriate to the risk level you're willing to take with this bond. You might sacrifice some yield but the level of risk you undertake would probably go down a lot since you've diversified individual company risk away. I wouldn't ignore the MBS market with equivalent ratings. Ford bonds tanked and I know some are yielding 10% or so. At least compare the GMAC and Ford bonds. I would think that your advisor would be able to answer a lot, if not all of these questions if they know what they're doing.

[adios]

You said it a lot better than I did as I responed before reading yours. What he said Bill /images/graemlins/smile.gif.

[Bill C]

Thanks, Player, and Adios, and all others who responded. The proposed investment is part of a "bond ladder" that represents a portion of my portfolio, and would represent perhaps 3% of the total. None the less, I am not anxious to have a default, even if I would have partial recovery. AMOF, I had a similar holding in Conseco which defaulted a couple of yrs ago.

In that context, and with the helpful comments, I am a little less concerned. I don't have to make any decision right away, and will mull it over until next week.

Thanks again. This was really very helpful to me.

Sincerely,
bill c /images/graemlins/smile.gif

[midas]

Bill

Let see how smart your advisor is. Does he/she realize that GMAC is potentially up for sale? Change of control could execute automatic call provisions and thus effect yield. This may not be a long term investment.

Also, never invest in something you don't understand.

[player24]

[ QUOTE ]
Bill

Let see how smart your advisor is. Does he/she realize that GMAC is potentially up for sale? Change of control could execute automatic call provisions and thus effect yield. This may not be a long term investment.

Also, never invest in something you don't understand.

[/ QUOTE ]

Some bond indentures, including nearlly all high yield indentures, include a provision whereby a change of control results in a company obligation to tender for bonds at 101. Given that GM and GMAC bonds are currently trading below 101, a change of control would be additive to the return on investment.

I don't know for sure - but it is unlikely that GM bonds have change of control provisions (given that the bonds were issued when the company was an investment grade credit, and change of control tender provisions are unusual for investment grade bonds.)

From the perspective of a GM bondholder, a sale of GMAC (unlikely) or a division of GMAC (possible) would not constitute a change of control. In the event of an asset sale, the company could use the proceeds ro retire debt or reinvest in the same line of business. GM would probaly retire debt (because they have debt maturities which would qualify as debt reduction) but the debt retirements would be at 100, at maturity - and would therefore, not effect the effective yield of the investment.

In general, the market will view an asset sale by GM positively - and owners of GM bonds may experience a mark to market gain (as the bonds trade higher on the belief that near term default risk is lessened by the enhanced liquidity associated with an asset sale). This "could" enhance your holding period return, to the extent you are inclined to sell your bonds at elevated prices following an asset sale. In the current environment, at current prices, it is very unlikely that an asset sale would be negative for a GM of GMAC bondholder.

[Misfire]

a) 10% is not a high enough rate of return. You could invest for a slightly longer term in growth stock mutual funds and expect a return as good or better with much less risk.
b) Fire your advisor if he would even think of selling you a product he knows you don't fully understand.

[gvibes]

[ QUOTE ]
a) 10% is not a high enough rate of return. You could invest for a slightly longer term in growth stock mutual funds and expect a return as good or better with much less risk.


[/ QUOTE ]

This is downright idiotic. You realize that, historically, growth funds have returned less than "value" funds?

I realize that there are no guarantees that the patterns of the past will continue.

[jpg7n16]

[ QUOTE ]
As part of my retirement portfolio, an advisor has suggested I purchase a "high yield" bond in a company that has some chance of going under during the 3 year term of the bond. Obviously he feels it is unlikely that it WILL fail, but admits there is perhaps a 10% chance the company will fail. The bond is yielding approximately 10%.

How do I calculate EV here, and how can I best understand the risks involved in terms of mathmatics?

Any help would be greatly appreciated.

bill c

[/ QUOTE ]

Assuming you are paid 10% every year, and it is not compounded, mathematically here's how you would find it: (for every dollar 'X' invested)

Your base formula stems from:
(%chance of outcome one*event one)+(%chance of outcome two*outcome two)

90%(Original Investment plus 3 10% payments)+10%(Lose original investment)

90%(X+3*(10%*X))+10%(-X)
.9(1.3*X)-.1*X=
1.07(X) = Original Investment + 7%

Your EV for this case is 7 cents for every dollar invested:

$1,000........................EV=$70
$100,000.....................EV=$7,000

and so forth...

Mathematically that's how you do it. Of course the calculations would be different if you chose to evaluate other considerations such as inflation. But that's a good estimate. If he's correct and there is only a 10% chance of losing your investment, you should go ahead and invest if you are happy with a 7% return or higher.

Edited to add: ... and you are not risk adverse.

[RedManPlus]

[ QUOTE ]

Your best EV may be to fire the advisor. If he's putting you into a risky investment that you don't seem to understand, that's a big -EV right there. It makes me wonder how much he is charging you, and how fair that is, and how safe the rest of your investments are.


[/ QUOTE ]

This is a good analysis.

First off...
Neither you nor your "advisor"...
Will have any accurate way to quantify the likelihood...
That the company will go bankrupt.

The best predictor of this...
Is the bond market.

And the bond market has valued the paper as junk...
Meaning significant risk of default.
It depends on the actual credit rating...
BB might still be OK with 10% risk of default...
But when you start getting into B and C...
Forget it.

A good recent example in General Motors.

GM bonds have dropped over 20% since Jan 1st...
And the yield has gone from about 7 and change to 10.0%

The pros in the bond market are saying...
And putting their money where their mouth is...
That GM's business model is obsolete...
And they are headed for bankrupcy.

Of course...
GM may "too big to fail".
Congress will likely bail them out...
The way they bailed out Chrysler in the 70s.

If you want to gamble...
Buy GM or Ford preferred stock.

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif

[Recliner]

I don't see the point in buying preferred stock as the bonds carry less risk than stock. If he were to buy some bonds and the company does go bankrupt he'll still end up getting some percentage of the value of the bonds back, and the same can't be said for the preferred stock.

You are correct however than even thought the bond agencies haven’t dropped GM's rating to junk, that is what the market views it as. GM is the 3rd (I believe) largest issuer of debt in the US with something like 113 billion dollars issued. Everyone is doubtful that the government is going to let them fall on their ass.

Also you can check out the current yields on all outstanding bond issues here yahoo bond screener (http://bonds.finance.yahoo.com/z1?b=1&is=general%20mtrs&sf=m&so=a)

[RedManPlus]

Yeah... you're right...
Bond holders always get paid first.

But preferred stock holders get paid second.

Actually...
I follow and trade 11 GM issues on the NYSE...
And most GM "preferred stock"...
Is actually GM bonds chopped up into $25 units.

For example GMS...
Is GM 7.50% Senior Notes due 7/01/2044...
Chopped into $25 units...
Now trading at $19.60 and yielding 9.54%.

If you believe that Congress...
Will never allow the US car industry to disappear...
Then these securities are a fabulous 6-12 month investment.

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif

[player24]

Q: Why buy a preferred stock with a lower yield and higher dollar price than bonds of the same issuer which have a comparable maturity?

A: In most cases, you should demand much greater compensation for owning the preferred stock of a high yied company. Your investment in preferred will recover much less than the bonds in a bankruptcy.

But: This case is somewhat unusual. The security being referenced has a bond indenture (contractual coupon payment) and is pari passu with GM senior unsecured debt.

However: This security is not "true" preferred stock. If it was, it would be yielding much more than the debt.

And: The stock looks remarkably expensive versus the debt. The best GM trade is to short the stock and buy the bonds in an appropriate ratio (currently about 2.5:1). You will gain under nearly any scenario - the one exception being if the stock rallies by more than 50% in the next year. GM does not deserve a $15 billion equity market capitalization.

Finally: GM is not too big to fail. A bankruptcy won't put the company out of business (probably). Most large corporate bankruptcies simply transfer the ownership of the company - debt holders become equity holders...and equity holders become dust. Preferred can recover more than common equity, but the difference is often small. The US economy is large and diverse - don't expect Congress to act to protect GM creditors and equity holders.

[midas]

Spoken like a true hedge fund guy!

FYI - GM is too big to fail, similar to Chrysler, the U.S. gov't would never let GM declare bankruptcy - the ripple effect through the U.S. economy would be severe - can you imagine GM saying to all its suppliers - sorry I can't pay!!! Bankruptcy for everyone!!!

[RedManPlus]

Kirk Kerkovian disagrees with you.
He thinks that the finance unit alone is worth $30/share...
And you get the car business for free.

Actually...
I don't "buy" stocks... I only trade them.

Today I made 85 trades...
41 in GM "bond equivalents" and 6 in Ford "bond equivalents".

All I want is more car stock volatility.
I don't care if they go up or down.

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif

[adios]

Nice posts guys. From what I understand Kerkorian is long at GM at around $25 and offered to buy more at $31 even though GM was trading for less. Supposedly shorts including the hedge funds that are doing the long bond and short stock trade Player24 mentioned have to start covering due to Kerkorians bid. Perhaps this is a way for Kerkorian to sell and make a decent short term profit. I guess Kerkorian made a killing on Chrysler way back when though.

FWIW the UAW liabilities that GM has seems to be killing them. I'm wondering if a chapter 11 would be a way to lessen those liabilities.

[player24]

[ QUOTE ]
Kirk Kerkovian disagrees with you.
He thinks that the finance unit alone is worth $30/share...
And you get the car business for free.


[/ QUOTE ]

The finance company may be worth $30 bucks per share (although I think this is a bit of a stretch, $25 is my estimate). However, "free" is too expensive for the auto company.

The auto unit has a $96 per share liability for Pension/OPEB and net debt of $5 per share. Assuming gross automotive assets are worth $101 per share, then GM stock could be worth $25 to $30 per share.

Maybe Kerkorian can unluck the finance unit value before the automotive operations burn more cash, lose more market share and negate all of the value of the finance unit? Operationally, GM is a sick puppy...and I don't think management gets the joke (yet).

In the near term, I won't fight the tape. Kerkorian caught the shorts leaning. (He could be selling his stock today - or he may think he can influence management to begin to liquidate the company.) I don't think that Kerkorian is going to improve GM's SUV sales.

Longer term, I will bet on the fundamentals - which are decidedly negative with no turn in sight. Restructuring this company is going to be a long and painful process.

[meow_meow]

[ QUOTE ]
Kirk Kerkovian disagrees with you.
He thinks that the finance unit alone is worth $30/share...
And you get the car business for free.


[/ QUOTE ]

Yeah, GMAC makes lots of money. Too bad it's bundled with the car business, which loses lots of money. I don't want the car business for free.

[natedogg]

This sounds very fishy. Why is he pushing this risky bond onto you?

Try researching Canadian Royal Trusts. They are oil and gas interests that pay huge dividends. Hell I just found a US stock NGT that pays a 9.2% dividend. It is a natural gas trust.

There are european utilites that pay close to 10% dividends too. There's LOTS of ways to earn close to 10% with MUCH less risk.

At least with a gas trust you know people want to buy gas. I don't know what this company is but it sounds fishy the way its being pushed onto you. I would CERTAINLY not put a significant portion of your investments into a single company's junk bond. A junk bond FUND is scary enough.

natedogg

[RedManPlus]

There is no free lunch.

Any stock yielding around 10%...
Either has significant default risk...
Or the dividend is not sustainable and will be cut.

So you have to dig a little deeper.

It takes about 3 minutes to check out NGT via Yahoo.

They change the dividend amount each quarter...
So a yield calculation based on the last payment is misleading.

In the last 12 months they've paid out $2.02...
And they've earned $2.04...
So NGT's yield is actually about 7.5%

And this is not risk free.

You are also exposed to the volatile energy sector...
And after Enron and friends...
God only knows what really goes on with some of these energy companies.

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif

[adios]

[ QUOTE ]
Any stock yielding around 10%...
Either has significant default risk...
Or the dividend is not sustainable and will be cut.

[/ QUOTE ]

Have to disagree here with this statement. When a company pays out nearly all of it's earnings as dividends which is the case for almost all the CanRoys, the yield should more or less represent the risk premium that investors demand for a stock. ERF has been around for a long time and I think over the past 15 years or so with dividends re-invested it's far outpaced the market. Buying CanRoys is a play on the price of Oil and Natural Gas for the most part as well as play on the Canadian $ vs. the U.S. peso. CanRoys differ from there US counterpart AmRoys in that CanRoys can acquire additional energy assets while the assets for AmRoys are depleting. Are CanRoys highly leveraged? You betcha thus the higher yields. Also if one wants to really trade the CanRoys you probably should get a broker where you have access to the Toronto exchange.

Some of the best analysis of CanRoys, energy companies, and high yielding stocks that I know of can be found at ValueForum.com. It costs about $100 a year for to have full access to the site but it's well worth it.

[RedManPlus]

You just proved my point.

In order to get a 9.3% yield...
And possible capital appreciation...
You have to make a "play" or bet or gamble...
On the price of oil... plus currency risk.

ERF tanked by 25% in the wake of Enron...
And tanked about 20% in the spring 2004 bond swoon...
And has recently lost 15% in 2 months as crude slid.

I've traded "bond equivalents" for a living for 10 years now...
And there is no free lunch.

You never, ever get a 10% yield with a AAA risk profile.

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif

[snowbank]

Ask him if he makes the majority of his income from being an "advisor" or an investor. If he makes the majority of his money from being an "advisor", or whatever it is he does for a "job", find a new advisor. Why would you take advice on investing from anyone but a professional investor?

[RedManPlus]

I don't necessarily disagree with you.

But here's the problem:

Only about 10% max of traders make a living...
And about same 10% of "money managers" OUTPERFORM the market by say 5% or more.

The other 90% are Pretenders...
And their opinion is of no value.
Most are simply "Securities Industry Operatives"...
Using a large variety of titles and methods...
To TAKE YOUR MONEY.

Never, ever forget...
There is only one reason for Securities Industry to exist...
And that is to transfer wealth...
From the Public to the Securities Industry.

The previous statement often throws people...
Since most people are brainwashed...
By a lifetime of advetisement carpet bombing...
To believe that the Securities Industry is there to "help" them.

Bwa-ha-ha-ha-ha-ha.

Anyway...
I have run a very profitable small hedge fund for 10 years...
And I can't be bothered giving people advice...
Because everybody is so f***ing brainwashed.

Only people who think completely outside the box...
Can outperform...
Whether trading or investing.

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif

[player24]

RedManPlus, You have asserted your supreme expertise a number of times in this thread. And you have made sweeping criticisms and generalizations. Can you possibly become more insulting or condescending?

[adios]

It would be hard to be more condescending and arrogant. He's posted stuff that's just wrong and I'm sure I'll get a flame here from him but once that's pointed out I'll just ignore his posts and move on. One of the great things about the market and poker for that matter is that one doesn't really have to justify anything but the bottom line for the most part.

[midas]

When an advisor recommends any type of trade ask the following questions:

1. How did you come about this advice that you are giving to me? Find out if the advice/trade is basically just the firm advice being pushed on the salesforce.

2. Why is this a good deal/investment? Have your advisor explain the rationale behind the trade. You'd be amazed how many brokers/advisors have no clue in the underlying fundamentals of the investment. Ask things like forward PE ratios vs. the industry. Check the chart - are you buying at a high or low point? My mother's advisor once put her in Citigroup at the absolute high point in a cyclical stock.

3. Is this investment right for me? I've seen investors chase high-yield bonds not realizing that if interest rates go up they could lose principal.

4. Treat you financial advisor like a car saleman. Most people have no idea how you become an advisor - I'll bet that most people think you have to graduate from college to become a broker - wrong!!! Most people think that passing the Series 7 prepares you to give good financial advice - wrong again.

In general, most people know more about their cars than the investments in their portfolio.

[DesertCat]

[ QUOTE ]

FYI - GM is too big to fail, similar to Chrysler, the U.S. gov't would never let GM declare bankruptcy - the ripple effect through the U.S. economy would be severe - can you imagine GM saying to all its suppliers - sorry I can't pay!!! Bankruptcy for everyone!!!

[/ QUOTE ]

Filing for bankruptcy is done to ensure that all the suppliers can be paid. As a previous poster noted bankruptcy just eliminates the fiction that the common stock is worth something, and transfers all ownership to GM's debtors. It also allows management to get rid of much of it's pension and healthcare obligations, and hopefully right the company so it can return to making cars profitably.

There is no need for government intervention. In fact you can argue with U.S. labor costing $100 per hour in salary, overtime, benefits and pension obligations that a quick bankruptcy would be very good for our economy. Uneducated blue collar auto workers would have to get by on, say $40 per hour, but at least they'd still have jobs. And more cars would be made in Detroit, benefiting everyone.

[adios]

My sense now is that Kerkorian would like to see GM spin off GMAC because he feels that the GMAC portion is worth over what he's paying for GM shares.

[gvibes]

[ QUOTE ]
Filing for bankruptcy is done to ensure that all the suppliers can be paid. As a previous poster noted bankruptcy just eliminates the fiction that the common stock is worth something, and transfers all ownership to GM's debtors. It also allows management to get rid of much of it's pension and healthcare obligations, and hopefully right the company so it can return to making cars profitably.

[/ QUOTE ]

The all bankruptcy-getting-rid-of-pension-obligations doesn't seem to working for United. Then again, my bk law knowledge is somewhat less than mediocre.

[DesertCat]

[ QUOTE ]

The all bankruptcy-getting-rid-of-pension-obligations doesn't seem to working for United. Then again, my bk law knowledge is somewhat less than mediocre.

[/ QUOTE ]

The BK judge will eliminate United's pensions this week. (http://www.washingtonpost.com/wp-dyn/content/article/2005/05/09/AR2005050900958.html) Of course this won't fix their business model, but it gives them some breathing room to figure things out.