Thursday, July 22, 2010

BP distressed debt arb

I've been reading about BP's 1-year commercial paper yielding over 10%. I don't have access to a bloomberg or other real-time sources to check out what the prices were a few months ago but that sounds like at least a 50% price drop since pre-oil-spill to me (if someone has a graph of 1-year yields or CDS yields, please post it in comments). If it's paper is down 50%, then logically its equity should be down way more than 50%, right? But it's not, it's only down a little less than 50% since pre-oil-spill. So buy commercial paper (or buy bonds, or short CDSs), short BP equity, and you should make money no matter what happens to BP.

Scenario analysis of two possible extremes:

A) BP is just fine, doesn't pay out hardly anything in environmental suits (pretty much impossible right now). Commerical paper and equity both double back to where they were.
B) BP goes into bankruptcy and can't meet all creditors claims. Equity goes to 0 (actually, for as long as the equity trades, it would likely stay ever so slightly above 0 just b/c stocks simply don't trade down to 0 for as long as they exist, like FNM/FRE right now). Creditors aren't made completely whole, but get some fraction of par, probably a large fraction. Value of commercial paper stays way above 0 b/c a good-sized chunk of it is still paid out.

So as long as you are long fixed income in slightly larger size than you are short equity, you should make out well. However, I would personally tilt the hedge a little more heavily on the short side, as I don't see BP coming back much higher for years at least.

This arb is probably possible because a whole bunch of funds were forced to dump BP's debt at the time it was downgraded, no matter what fair value should be, while equityholders were not forced into such a firesale.