Blog
Subscribe to Posts
Previous Posts
Don't Get Scammed by Investment Spam
Archives
Blog
August 26, 2008
Buy the Debt, Sell the Stock
Seems like every day there's a new story in the press about Fannie Mae, Freddie Mac, CIT, Lehman Brothers, Washington Mutual and every other financial services firm that's been caught up in the ongoing mortgage crisis. The stock prices of each of those firms have plummeted as much as 90% in the last year, and there are few compelling reasons to buy them even at today's rock-bottom valuations.
On the flipside, however, there are some strong reasons to buy bonds issued by these companies. In fact, Freddie Mac just sold $2 billion in short-term debt that was well received by Wall Street. That's because stocks and bonds are treated very differently if a company is forced to file for bankruptcy. According to the U.S. Constitution, bankruptcy proceedings are handled by federal law and there is a very clear pecking order for those with claims against a bankrupt company.
It should come as no surprise that bankruptcy lawyers and the IRS get paid first, followed by employees and the company's pension fund, if any. Next up are creditors – i.e., people and companies who have loaned money to the bankrupt firm. Among this group of creditors are bondholders because, technically, when you buy a bond you're loaning money to the issuing company. It's only after all creditors are paid that any residual money is given to stockholders, with preferred stockholders being paid before common stockholders. So unless a company truly has no assets of intrinsic value (e.g., factories, branch offices, warehouses, etc.), bondholders can usually expect to receive all or some of their underlying investment.
Does that mean you should run out and buy bonds from these distressed companies? It depends on your circumstances and appetite for risk. But with yield-to-maturity rates of 8% to 15% for the short-term debt of companies like Ford, GM, and CIT, investing a small portion of your portfolio in these bonds might make sense.
On the flipside, however, there are some strong reasons to buy bonds issued by these companies. In fact, Freddie Mac just sold $2 billion in short-term debt that was well received by Wall Street. That's because stocks and bonds are treated very differently if a company is forced to file for bankruptcy. According to the U.S. Constitution, bankruptcy proceedings are handled by federal law and there is a very clear pecking order for those with claims against a bankrupt company.
It should come as no surprise that bankruptcy lawyers and the IRS get paid first, followed by employees and the company's pension fund, if any. Next up are creditors – i.e., people and companies who have loaned money to the bankrupt firm. Among this group of creditors are bondholders because, technically, when you buy a bond you're loaning money to the issuing company. It's only after all creditors are paid that any residual money is given to stockholders, with preferred stockholders being paid before common stockholders. So unless a company truly has no assets of intrinsic value (e.g., factories, branch offices, warehouses, etc.), bondholders can usually expect to receive all or some of their underlying investment.
Does that mean you should run out and buy bonds from these distressed companies? It depends on your circumstances and appetite for risk. But with yield-to-maturity rates of 8% to 15% for the short-term debt of companies like Ford, GM, and CIT, investing a small portion of your portfolio in these bonds might make sense.
