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 ]
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.

[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.

[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+

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[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

[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+

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[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.

[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

[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.