I've strayed from my bailiwick recently. With little to say about bonds, and little to recommend them, I've focused on other themes, particularly stock buybacks and the silly optimism that accompanies them. Well, I'm not backing away from this line of discussion at all, and have full confidence that time will validate my profound skepticism about the entire concept. So, I'll be commenting further as time passes, as my keen analysis bears fruit (!).
Twice before, I've kind of thrown in the towel, metaphorically, when it comes to bonds. Two once-in-a-lifetime opportunities (2008-9 mortgage crisis, 2010-11 Euro crisis) receded, and low-yield high ennui situations prevailed. And yet ... once again ... the relentless flow of current events brings me sharply back to new, inviting, and perilous opportunities in the wonderful world of bonds.
Not surprisingly, it all relates to oil, and the shocking collapse in prices that is revolutionizing world markets. Where to begin, where to end? Well, first and foremost, ignore the folks who argue that it's all a massive head fake. No, it's not that Obama (or Saudi Arabia) has a secret plan to crush Putin and Iran. It's actually simple: oil and gas prices are down, way way down, because the iron law of supply and demand is finally kicking in. Huge sources of new production have been coming online for several years (due to fracking in the US and Canada, and the slow recovery of production in other critical regions), while persistent political unrest has kept prices artificially high. The turning point is opaque (why now, why not a year ago?), but that very delay has magnified the downward price shock.
Huge movements like this (oil below $50/barrel!) cause turmoil, and turmoil, in turn, breeds confusion and fear. FEAR (think of it as negative GREED) is one of the most reliable and powerful forces in the market. And yes, dear ones, GREED is in fact the other. When it comes to bonds, fear is particularly powerful. Bond investors scare easily, and perceived threats to the stability of bonds make them bleat toward the exits.
So, what is getting stampeded right now? Of course, oil companies, and the companies that service them. Not surprisingly, many pundits are predicting catastrophe.
But, this whole tempest needs perspective. Is this a near-death event like the 2009 mortgage meltdown and the 2011 Euro crisis? Highly unlikely, I think. Russia will be on the ropes (oh, TOO BAD!), as will Venezuela and various other petro states. Yes, there's also a nasty round of currency devaluation going on, which could trigger recessions. On the other hand, consumers world-wide have just been gifted a huge cash infusion, via lower gas prices. That should cushion the shocks to what is, after all, a limited portion of the world economy. Common sense suggests that the solution to low gas prices will be ... low gas prices! New exploration and development will be postponed, consumption will pick up, and oil will start rising again. Political instability in any one of a dozen places could send prices soaring. How far, and when? Heck if I know. But we've been down this road many times, and I doubt it ends at Mt. Doom.
Let's get specific about this latest tempest. Transocean (RIG) is the biggest oil drilling
company in the world. But, over the past two years it has dropped from $58
to $16 a share, a 72% pummeling. The dividend is now a stratospheric
18%.
Here's a helpful hint: that dividend is toast (not right away, but zwieback nevertheless). To buy the stock hoping to feast on that dividend would be stupid (really stupid). However, does this mean that the stock is dead? Or better asked, is Transocean dead? I think the answer is very clear: no. While both Moody's and S&P are threatening to downgrade Transocean's debt to junk level, I think there's a reasonable chance that one or both will hold back. Transocean has a well-diversified array of drilling units, many stable long-term contracts, and a pretty good stash of cash (over $3 billion, with current liabilities of $.9 billion). If it eliminates that dividend (it will, it will), another $1 billion is added to the company's cash. It has assets to sell, if needed, and can mothball other units to minimize the cash drain they represent. I suspect the company will find a way to fend off the downgraders.
However, the mere possibility of a downgrade has the faint of heart fainting heartily. Take a look at Transocean debt: One example, the 6.8% bonds of 2038, now trading around 80, for a yield to maturity of 8.8%. Those are yields associated with B- rated junk, perhaps six rating levels below the present (shaky BBB-). So, ask yourself, is Transocean really that close to the abyss?
Absent a default, what would a purchase of this issue offer? Well, a present yield of 8.8%, for 23 years! At maturity, a guaranteed 25% return on the initial investment, as the issue returns to par. This is the plain vanilla scenario. Add in a soupcon of leverage (say borrowing one dollar for each dollar invested), and the present yield sky-rockets to 15.75% (assuming that beautiful Interactive Broker margin rate of 1.25%). Imagine a return to par in five years, and the $5150 net profit (on $4000 invested and $4000 borrowed on a ten bond position) would be a gorgeous 128% of the initial investment, or 18% compounded. This is the stuff I dream of, and, to toot my own horn, that dream has been realized over and over in the past six years.
What if the future is less rosy for Transocean? What if, gulp, it actually crashes and burns? Well, here again, the beauties of bond investing come to the fore. As legal obligations of the company, the bonds must be repaid, if liquidation yields enough to do so. As the company presently has roughly $32 billion of assets, and roughly $12 billion of long and short-term bond obligations, it certainly looks like repayment (of principal AND interest) would be a pretty safe bet.
I am sure it comes as no surprise to my loyal readers (of course, since there are none at present, they are not easily surprised, or loyal, for that matter) that I have started buying these bonds, small nibbles of $5 and $10k at a time. So far, I have modest paper losses, which is keeping me cautious. If the bonds start a sustained recovery, I intend to get greedy, shades of 2009!
How about investing in the stock itself? Ordinarily, I'd say no, citing the almost endless list of things that can go wrong with stocks as a class. But here? As I've mentioned many times before, opportunity knocks when blood is in the water, things are ridiculously cheap, and fear holds you in absolute paralysis. Does Transocean (and the entire energy sector) meet these criteria? Hell yes. A recent seekingalpha column concludes the stock has 100% upside, even if oil remains at present levels, and earnings slump $1 billion in 2015. So, I intend to nibble on a few deep-in-the-money Transocean calls maturing in 2017. These babies could go to zero, or soar tenfold in the next two years. I'm obviously betting on the latter, but in no case betting a lot. I'll save most of my greed and aggression for the bonds instead.
How long will this particular once-in-a-lifetime situation last? Three to six months is my guess. Then oil prices will stabilize (probably at relatively low historical levels), oil-related companies will stagger slowly back to reasonable valuations, and their bonds will resume life as boring and low-yield creatures of the field. So, the opportunity lies between now and then. Be brave now, or curse the wasted opportunity later.
Update: Tax day, 2105. It's been about three months, so half-way through the window of opportunity described above. It's been mostly downhill, until just this week. Suddenly, the stock has jumped sharply from below $16 to nearly 19, most of the move today. My long calls have risen from a fairly substantial loss to an equally substantial paper gain. My bonds are still down a bit, following the ratings downgrades, but now only a little bit. So, the window is still open; but three more months might, as hypothesized, spell the end of this particular opportunity. I've been nibbling today; and may start gulping soon.
