See Part 1 first.
Capital Structure Arbitrage
In the 10-Q from July 29th, 2010,
we see the following indebtedness table. The $150mm converts maturing in June 2011 presented a major liquidity challenge and a potential bankruptcy catalyst. They couldn’t just pay it off with the bank facility (I think), their main liquidity source.
5.125% Convertible Senior Notes, due June 15, 2011 $ 157,677 $ 155,333 Related Party Promissory Note, due August 18, 2011 10,000 10,000 9.125% Senior Notes, due December 15, 2011 12,840 12,840 6.750% Convertible Senior Notes, due December 15, 2012 226,741 223,838 11.375% Senior Secured Notes, due August 4, 2015 253,928 253,668 9.375% Notes, due August 1, 2039 200,000 200,000 Borrowings under Credit Agreement 132,900 132,900 Other 2,702 1,971 ----------- -----------
Now I wondered if there was cap structure mispricing. First, I was intrigued by the 9.375% Notes. They were an unusual instrument called QUIBS, securitized quarterly interest bonds traded under “GAJ” on the NYSE.
Looking up the prices, I saw that the 6.75% Dec 2012 Senior Converts were trading around $56 (56% of par) and that GAJ was trading around $18. 18?! I was excited by how cheap that was until discovering that the notional was $25, or 72% of par.
Structuring The Trade
The mispricing was not immediately clear to me. There were other securities to examine, and yield and cap structure positions to compare. Eventually, I worked out the trade: long the Senior Converts while shorting an equal notional amount of GAJ. You’d short 40 shares ($1000 notional) of GAJ, getting $720 in cash, while longing 1 Senior Convert ($1000 notional) and paying $560 in cash .
GAJ current yield was around 9.375/72 = 13% while Senior Converts current yield was around 6.75/56 = 12%, so you’d be paying north of 1% of N each year to put on this trade (quarterly vs. semi-ann). But if they had the same seniority, one of two things could happen.
- GAP would somehow turn around and pay off the Senior Converts in Dec 2012 at 100. I would expect GAJ to rally to slightly north of $25, but not exceed 100% of par by much. Thus, you make the substantial 16% (=72-56) of N spread by Dec 2012, carrying the -1% of N until then.
- GAP would go bankrupt sooner, the securities would be forced DOWN, and you’d make the 16% (=72-56) of N spread, carrying the -1% of N until then.
Basically, other than the carry and the Senior Convert conversion option (both negligible), we had the same security trading at 56% of par and 72%. They would be forced to meet in price either in bankruptcy (perhaps around 0?) or in solvency (near 100) in two years.
Considerations and Disappointment
I couldn’t believe such clean arbitrage existed, so I had to verify that GAJ and the Senior Converts were indeed pari passu. This meant diving into the original bond prospectuses. They were hard to understand, so I wasn’t fully confident, but it was clear enough to send an e-mail to my fund PM.
I wish the story had an ending where the PM put the trade on in size, but I was ignored. I was headed home anyway the next week anyway, so I didn’t have time to keep pestering. But I realized that GAJ, because it was securitized, could be shorted by retail brokers at no borrowing cost (besides the quarterly interest).
Executing the Trade
I put on the following series of trades for my personal account:
In August, I shorted 200 sh GAJ (without longing the Senior Converts) to play my bankruptcy idea. I was lucky to cover at $13.5 because it came roaring back up in September, as GAP sold off a few stores and people responded to the extra liquidity enthusiastically.
In September, I put on the arbitrage trade, longing $5000 notional of the Senior Converts (CB4AK9) while shorting 200 shares (also $5000 notional) GAJ. As GAJ continued to climb into October, I put on a pure short of 400 shares of GAJ at $20.25/sh. At this point, I had serious doubts about my research and the trade, but luckily school and job-hunting distracted me from doing anything rash. Over November, the stock came back down, and I covered 200 sh of the pure short.
As you might guess, GAP announced bankruptcy on December 12, 2010. Notice that I covered GAJ at $3.5/sh or 14% of par, while I sold the Senior Converts at 27% of par! Ironically, the spread had swung the other way – GAJ was now underpriced relative to the Senior Converts. And of course, my 200 sh pure short of GAJ was still on and probably made the most money of all.