I have spent 30 years trading, investing and managing risk for a living and the last 18 of those years I have been deeply involved in what is called credit.
Credit is broadly defined as corporate debt or corporate bonds but encompasses all kinds of crazy derivative instruments (including the kind that blew up the world in 2007/2008...remember they called it the Credit Crisis?). Anyway, when I traded credit at Merrill Lynch Canada for 10yrs as the Head of Canadian Credit Trading, I was fortunate enough to be there at a time when the firm wanted guys like me to take a lot of proprietary risk. The banks and dealers back then (pre 2008) were really giant hedge funds.
What was interesting about what we were allowed to do was to put risk on all across the capital structure of a company. That is to say, we didn't just buy corporate bonds, we invested in bank debt, convertibles, preferred shares and even common equity. And we didn't always just buy or go "long" positions, sometimes we would "short" or "sell short" other positions, in the hopes, based on our deep fundamental research, that our long positions would go up and our short positions would go down...The Holy Grail of Investing.
The real benefit of this skill, knowledge and experience is that this is real investing. To just look at buying a company's common equity (because that is all you have visibility on or can get your hands on) is myopic, to say the least. I will elaborate in a minute, but first, here is an intro on the capital structure of a corporation:
The first thing to know is that being at the top is best...more secure a position in case something bad happens to that company. If a company restructures or declares bankruptcy, you want to be invested as close to the top as possible. The bottom is the most volatile and usually weakest position but also has the most upside.
So at the top, we have Senior Secured Debt or Bank Debt. This is secured against all or some specific assets of the company so if there is a restructuring the Secured Lenders will likely get paid close to 100% of what is owed to them. Bank lenders are typically in this position but often some corporate bonds are as well. Bank Debt and Secured Bonds typically have a lot of "covenants" that the company needs to follow or they may find they are in default, which they obviously want to avoid.
Next down is Senior Unsecured Bonds (including High Yield bonds). So these bonds are not secured against specific assets and if there is a restructuring of the company;s debt, then typically the Senior Secured Debt gets paid 100% first and then the Unsecureds get whatever is left over. (This is called a Waterfall). Unsecured Bonds typically have covenants as well which are there to protect us as bond holders. So this is the next "safest" position to be in.
Then we have Convertible Bonds. These are tricky. If the issuer runs into cash flow trouble, they can actually convert not only your maturity into common stock but they can convert your semi-annual coupon interest into common stock too. Convertibles typically have very few, if any, covenants.
Preferred shares are near the bottom of the stack. As I said on BNN in April, Preferreds are not Fixed Income,but are Senior Equity. They may pay a coupon today but if trouble ensues, they can easily cut or stop that coupon entirely and there are no repercussions to the company. Not exactly a "safe position to be in.
And lastly, right at the bottom of the stack, we have common equity. Common equity are the "owners" of the business so if the business really takes off, the projection of improved cash flow will be seen in the stock price rising. However, if the cash flows sink, and they have significant debt, the common equity will get hit hard. Any dividend yield is simply a promise to pay, like Preferreds, not an obligation to pay like a bond. So Equity has the most upside, but also the most downside with $0 often being the result during a restructuring
OK, so armed with this info, and going back to my 18 years of experience trading and investing across the entire capital structure of companies, I will explain why it is so important and opportunistic to have this knowledge and experience when it comes to investing.
At High Rock, as I did at Merrill Lynch, we invest for a total return. That is to say, we follow benchmarks but we are always investing to create a positive total return. And this is important because we want to be invested in securities where we feel the best intrinsic value is or the best risk-adjusted returns (we talk about this a lot). If it is the common stock that might be the best part of the capital structure to invest in, then we will do so. If it is a bond, further up the capital stack, then we will invest there.
Maybe an example would help. For the past year, we were long the common stock of company A. Something at this company changed so we sold about half of our stock position and used the proceeds to buy a convertible bond issued by company A (we moved up the capital structure of company A). The reason for the switch was because we developed a feeling that company A might need to raise equity capital (sell common stock) and if they sell common stock, that capital comes in at the bottom of the capital stack so it inherently helps add "support" to the convertible bonds we bought and they would go up in value while the stock would go down in value because of supply. Company A has yet to raise equity capital but I can tell you that the stock has come off about about 5% and the convertible bond we bout is up about 1%...not much, yet, but it could be soon.
Another example was getting long some oil and gas producer bonds. When we saw these companies start to issue common stock, we rushed out and got long some of their bonds because that new common stock raise was inherently good for the bonds Some of these investments have done very well...maybe not as well as some of the stocks (we got long some energy stocks too) at their very bottom but 15-50% returns with lower volatility is nothing to sneeze at. .
This is being tactical and is what our Tactical Model is all about. This requires lots of experience, skill, knowledge, research, and generally having our "ear to the track" on all of the names in our wheelhouse that we do research on and invest in so that we can be one step ahead of the market.
That is how we take advantage of our skill, experience and the synergies with managing some high yield funds for Scotiabank. .