Ideas Farm: Distressing debt

There is actually an easy-to-overlook logic to this bankruptcy trade. While it may be more fun to characterise it as merely the work of Robinhood retail crazies, this type of stock can see a short-term fillip as investors that have shorted the shares cover their positions, creating a so-called 'short squeeze'. Over recent weeks, this phenomenon may well have been exacerbated by enthusiasm about economic recovery prospects. Still, this is a trade few would want to take on given the likelihood shares in bankrupt companies will ultimately prove worthless.

But looking more widely at the share price gains from some of these truly diabolical situations, it may be tempting to think investors who want to play the 'dash for trash' should simply seek out shares in the lowest quality companies; the worst-of-the-worst, if you like. However, ignoring 'quality' when it comes to buying beaten-up stocks (the kind of shares found on these pages in our tables of shorts, downgrades and 52-week lows) is rarely wise. 

Intrigued by the price movement of bankrupt-company stocks, Verdad – a US investment firm that specialises in investing in the shares of cheap, indebted, smaller companies – trawled its database. It looked for the long-term relationship between share price performance and the level of distress shown by a company’s debt. Based on data from the end of 1996 through to the end of May this year, the research found a clear linear relationship between the pricing of a company’s bonds and the performance of its equity (see chart below). 

The average annualised equity return for companies with bonds trading at less than 20c versus each dollar issued was a negative 94 per cent; a total car crash! In fact, equity returns were negative all the way through to companies with bonds trading at 90c to the dollar. Companies with debt trading at between 90 and 100c delivered a positive 6 per cent. And the best returns were from shares in companies with debt valued at or above the issue price. These shares produced a positive annualised return of 17 per cent.  

A similar story was found when Verdad compared equity performance with credit quality based on the scores of rating agencies. Here the research found share performance started to deteriorate when ratings fell below a high single B rating. The annualised equity return from stocks in the least creditworthy category (CC and below) was a negative 34 per cent!

This research holds an important lesson for investors targeting the grubbier end of this recovery. Rather than buying the worst-of-the-worst, it's the best-of-the-worst that should provide the optimal trade-off between risk and reward – although still risky and volatile.

On that note, we continue to recommend selling shares in companies we believe face challenges based on their fundamentals. This can feel like a bit of a thankless task at times like these, but over the longer term it is best to avoid companies that look as though they are in weak positions, even if this sometimes means missing out on a great recovery play at ground-floor level. 

One of the stocks in our tips section this week is a case in point. Signature Aviation (SIG) has recovered 70 per cent from its lows, but has also recently appeared in both our table of most-shorted shares and forecast downgrades. We think the recovery in the stock has got ahead of itself. In the interest of balance, credit rating agency S&P gave its bonds a BB rating in April, putting it outside what Verdad found to be the credit-quality danger zone.

Click here to view this week's Ideas Farm tables in PDF form

Source: S&P Capital IQ

Source: S&P Capital IQ

Source: FCA

Source: S&P Capital IQ

Source: S&P Capital IQ

Click here to view this week's Ideas Farm tables in PDF form