{"id":48737,"date":"2020-06-12T15:30:05","date_gmt":"2020-06-12T19:30:05","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=48737"},"modified":"2023-02-10T13:34:02","modified_gmt":"2023-02-10T18:34:02","slug":"understanding-bankrupt-shares","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/fixed-income\/understanding-bankrupt-shares\/","title":{"rendered":"Understanding Bankrupt Shares"},"content":{"rendered":"\n

This is an article that I never thought I would need to write. Throughout my career, I generally stopped paying attention to the shares of a company after it declared bankruptcy. I could do that because I mostly traded options and index-linked products. Bankrupt stocks are usually removed from major indices and the shares typically trade below the lowest strike price of listed options. Out of sight, out of mind.<\/p>\n\n\n\n

Yet I recently have had innumerable conversations about the remarkable performance of shares in bankrupt or near-bankrupt companies. Some of the moves have been truly staggering. Much of the enthusiasm seems to be coming from newly-minted investors and speculators, but there have been eye-popping gains that have attracted a wide range of market participants. I feel behooved to make sure that our readers understand the basics of the bankruptcy process in order to better assess the extra risks involved in trading these shares.<\/p>\n\n\n\n

Let me be quite clear: the fundamental value of the common stocks of bankrupt companies is often zero. There are specific reasons for this that are unique to the bankruptcy process.<\/p>\n\n\n\n

Bankruptcy is a statutory process, and a complicated one at that. I would not dare to give legal advice about it (I\u2019ll leave that to my brother the bankruptcy attorney). Fortunately the vast majority of investors need not understand the subtleties of the law. A practical understanding of the basics is much of what is required to avoid many common pitfalls.<\/p>\n\n\n\n

Bankruptcies occur when companies are unable to meet the demands of their creditors. As with most things involving bankruptcy, there are several potential paths that the process can take, so we will focus on the most common. A frequent cause is that a company\u2019s cash flow is insufficient to service its debts to bondholders and other lenders. At that point the company or its creditors may opt for Chapter 11 protection, named for the section of the bankruptcy code that governs corporate reorganization.<\/p>\n\n\n\n

This is when it is crucial to understand corporate balance sheets. Shareholder equity is what is left over when liabilities are subtracted from assets. If the liabilities exceed the assets, it implies that the book value of the equity is negative. That typically means the stock is worthless. In practice the process is quite complex, but the key concept is that stock holders don\u2019t get paid until all the creditors are satisfied. A judge oversees the process, sorting out the competing claims of the various stakeholders. The judge ultimately decides which assets will be allocated to whom, and whether the company can be reorganized or needs to liquidate. In the event that the company can be reorganized while satisfying the demands of the creditors, there may be residual value for the existing equity holders. In practice, this is rarely the case.<\/p>\n\n\n\n

Fortunately for average investors, there is a simple way to estimate a shareholders chance of recovery \u2013 look to the company\u2019s bonds. If a bankrupt company\u2019s bonds are trading near par or with a relatively normal yield, the market is telling you that there may be a reasonable chance for the bondholders to be made whole, possibly leaving some value for shareholders. It is much more typical, however, for these bonds to be trading at small fractions of their par value. In that case, the bond market is implying that it is unlikely to be made whole. Remember, if the creditors can\u2019t be made whole, the stock will ultimately prove worthless.<\/p>\n\n\n\n

One of my rules of thumb is that when the bond and stock markets disagree, the bond market is more likely to be correct. There is a fundamental fact about bonds \u2013 their ultimate upside is capped but their risk of loss is total. A bondholder can receive no more than the periodic coupon payments and the final principal repayment. Because of that, bond investors often take a more sober view than their equity brethren. They can\u2019t afford to be seduced by the idea of infinite gains. Distressed debt investors are particularly sophisticated. They have a nuanced understanding of the bankruptcy process and the likelihood of repayment under various scenarios. If a distressed debt investor buys an insolvent company\u2019s bond at say, 50% of par, he is hoping to receive more than that. Maybe he receives 70 cents on the dollar. That would be a huge profit for that bond investor, but still leaves nothing for the shareholder. This is why I tend to use bond prices as a guide for the pricing of a stock.<\/p>\n\n\n\n

Consider these recent stock and bond prices for highly traded bankrupt companies:<\/p>\n\n\n\n

Closing Prices as of June 11, 2020<\/p>\n\n\n\n

\"\"<\/figure>\n\n\n\n

In each case, the bond market is telling us that they see a less than 50% chance of being made whole. In most of them, that is much lower than 50\/50. If the bond market is estimating tiny chances of recovery, is it rational for stocks to assume a residual value?<\/p>\n\n\n\n

There is one quirk that bears mention though. Bankrupt stocks rarely go straight to zero. It is tempting for short sellers to pounce on stocks that are fundamentally overvalued. In many cases, the demand for the stock loans necessary to accommodate short selling is so high that the borrow rate reaches extreme levels. In some cases, the loans dry up, forcing the shorts to cover in a situation known as a short squeeze. It would be incorrect for someone to assert that there is never money to be made by buying shares in bankrupt companies, but it is fair to highlight that those profits are far more likely to arise as temporary trading situations rather than from fundamental investing.<\/p>\n","protected":false},"excerpt":{"rendered":"

If a bankrupt company\u2019s bonds are trading near par or with a relatively normal yield, the market is telling you that there may be a reasonable chance for the bondholders to be made whole, possibly leaving some value for 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