How to calculate EV of this proposed investment?

[adios]

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

[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 [img]/images/graemlins/smile.gif[/img]

[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+

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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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