Derivatives and Default Bond Products - dummies

Derivatives and Default Bond Products

By Russell Wild

If you think of debt securities as safe and boring, look at some of these investments, which are built on derivatives and defaulted bonds. You could double or triple your money overnight . . . or see it shrink and fade faster than the bankroll of a drunken gambler in Vegas on a not-so-hot night.

Daring to delve into derivatives

In general, a derivative is a financial something-or-other whose value is based on the price of some other financial something-or-other.

Examples of derivatives include futures and options. Entire fun books are written on futures and options. Suffice to say that they allow you to leverage your money and make big plays on just about anything, including the price of pork bellies, orange juice, most stocks, and — yes — even “conservative-investment” bonds, too.

Futures and options allow investors to purchase a contract that says on such-and-such a date, you’re going to buy (in the case of a future) or you have the option of buying (in the case of an option) such-and-such a bond. The price is set today, not knowing what the price of the bond will be at that date in the future (the expiry date).

If, on that day, the price of the bond is 110 and you have a contract to buy it at 100, BINGO — you win! If, however, the price of the bond has dropped to 95, ZINGO — you lose! Futures and options allow you to put up relatively little money (the price of the contract) and possibly profit a lot . . . or lose every penny.

Warren Buffett has called derivatives (such as futures and options) “weapons of financial mass destruction.” And they certainly can be.

Lehman’s downfall

One derivative product, specific to bonds, is called the collateralized debt obligation (CDO), of which the most common is the collateralized mortgage obligation (CMO). Talk about weapons of financial mass destruction . . .

A CMO is a complicated beast created by a brokerage house. It is a certificate that represents partial ownership of a huge pool of mortgage bonds, such as Ginnie Maes, Fannie Maes, and Freddie Macs. Different owners in the pool get paid at different times, and the payments are contingent on the performance of the pool and the payoff of other partial owners.

Prior to the credit crisis that brought down such institutions as Lehman Brothers, many CMOs were created using pools of subprime mortgage bonds. The subprime mortgage bonds, in turn, were bonds issued on the mortgages of huge homes sold to people with small paychecks. When the people with small paychecks realized that they could not afford the huge homes, the pools cracked. And you know what happened then.

Should you invest in derivatives?

All derivatives are risky investments. That’s not the purpose that bonds serve in this universe. It’s not a good idea to dabble in either CMOs or bond futures. Professional traders, who live-breathe-and-die this stuff, will very likely clean your clock.

Banking on losses with defaulted bond issues

You know about junk bonds: bonds that offer high yields but carry high risk. Some bonds — bonds in default — are even junkier than junk.

What are defaulted bonds?

Bonds in default are almost always corporate bonds (very, very rarely municipal bonds). In default usually means that the company is bankrupt or very close to being bankrupt, coupon payments on the bonds have stopped, and there is an extremely high likelihood that investors’ principal — or a good portion of principal — will never be returned.

But miracles do happen. Companies that seem to be going under or are forced into reorganization sometimes make surprising comebacks. And when they do, or even if it looks like they might, big profits can ensue. Defaulted bonds sell, as you would imagine, at very deep discounts.

Should you invest in defaulted bonds?

Martin Fridson, CEO of FridsonVision LLC (an independent investment research firm in New York City) and something of an expert on defaulted bonds, says:

Buying a bond in default is the polar opposite of ordinary bond investing. You get no income. No security. You’re purely speculating that the price will shoot up and you’ll have a capital gain. Most people who buy these never see any gain.

They [people who buy defaulted bonds] may have been talked into buying the defaulted bond by a fast-talking broker, and that broker will make a nice gain. But the person who bought the bond will generally see nothing.

Ah, but what if you are already holding a bond that goes into default? Should you keep it or sell it? That depends, says Richard Lehmann, publisher of the Forbes/Lehmann Income Securities Investor newsletter. If you’re holding a municipal bond, keep it, he says.

The recovery rate on munis is very high, in part because bondholders are usually the creditors with the most clout — more than, say, retired schoolteachers and librarians lining up for their pension benefits.

If you’re holding a corporate bond that goes into default, that’s another story. Powerful banks and other creditors tend to get their money before you do. Defaults usually begin with an announcement from a company that it will cease coupon payments on its bonds.

Most often, such announcements come in November or December for tax reasons, says Lehmann. As soon as the announcement is made, the price of the bond will tumble as the market starts to panic.

After the initial panic, prices on defaulted corporate bonds usually, but not always, creep up. If you can get your hands on a corporate balance sheet, note what percentage of the company’s assets is intangibles, such as goodwill and brand names, says Lehmann.

A higher percentage of intangible assets lessens your odds of getting any of your principal back. A higher percentage of hard assets, such as land and property, increases your odds of recovery.