Explain "buying debt"

[CrazyAce]

I read this paragraph:

"Just about everybody thought Lampert was crazy in 2002 when he began buying up Kmart debt at around 40 cents on the dollar after the retailer filed for Chapter 11. Crazier still, Lampert loaded up more as the price sank to 20 cents, eventually boosting his total investment to $700 million."

And I simply do not understand what "buying debt" means, at least in this context.

I've Googled 7 ways to Sunday and can't find an explanation.

Can someone give me a rundown of "buying debt," and, if you're so kind, apply it to the article segment I quoted.

Thanks guys

[Evan]

It's a more complicated form of lending someone money. Basically though, you're lending someone money.

In your example, he bought $1 of face value debt for $0.40. This means he bought a promise to be paid $1 for $0.40.

[DcifrThs]

well it could mean 2 things:

1) buying the liabilities of the company from creditors (literal creditors. like wholesalers that provide kmart inventory via accts receivable)

2) buying the corporate bonds (if the company is not in bankruptcy...if it is, i don't know if corporate bonds still trade or if they stop trading until the creditors work out what % they get and what is left for bondholders? and then are the bonds sold to people who could buy them?)...in this case, buying debt in terms of bonds may be evaluated as "kmart issued a bond with a 1k face value. it is now trading at $200 (aka 20% or 20 cents on the dollar). therefore buying that debt may be doing so when it is overly cheap."

i think it is the latter.

Barron

[AvivaSimplex]

In this case it's 2, though 1 does happen, usually through specialized debt collection agencies. Corporate bonds do continue to trade through bankruptcy, with their value varying based on the expected outcome of the bankruptcy.

[DcifrThs]

[ QUOTE ]
In this case it's 2, though 1 does happen, usually through specialized debt collection agencies. Corporate bonds do continue to trade through bankruptcy, with their value varying based on the expected outcome of the bankruptcy.

[/ QUOTE ]

thanks, clears that right up!

whats the relative price volatility of corporate debt after a chapter 11 files? i'd think it would rise significantly.

are there options on corporate debt? thats a good way to bet on bankruptcy i think if it were feasible, buy OTM puts on the debt if you think there is a larger than priced in chance the corporation will file chapter 11.

how would those options trade? i would assume that as the probability of bankruptcy becomes not insignificant, those options start to price in that extra volatility. but if you get in early enough, i would think that you would make a ton on the rise in implied volatility.

is this analysis correct? did i miss something?

are these types of bets available? do you know anyone or have you had experience w/ those types of situations?

sorry to just ask questions w/o serious research but if you know that would save me the trouble and i'd be much obliged.

thanks,
Barron

[Groty]

[/ QUOTE ] are there options on corporate debt? thats a good way to bet on bankruptcy i think if it were feasible, buy OTM puts on the debt if you think there is a larger than priced in chance the corporation will file chapter 11.

[/ QUOTE ]

Yes. They're called credit default swaps. All the big investment banks make a market in them. It's a non-transparent, very lightly regulated market making it nearly impossible to know who owns them, who has written them, or whether or not the writer of the option will be willing and able to perform in the event of a credit default. They trade over the counter and don't go through an option clearing house, so it's really the wild west.

In the benign credit environment of the recent past, writing credit default swaps has been like free money. Hedge funds have approached them like insurance, belieiving that if they write CDS on a large number of creditors, the premia from the issuers who don't default will cover their obligations against the few that do after recovery. They certainly have super sophisticated models to assess value at risk, but it's really a grand untested experiment. My feeling is that adverse events in insurance happen more or less randomly. For example, if a neighbors house 3 blocks aways accidently catches on fire, there's no reason to think my house will accidently catch fire. But when an economy turns down, financial distress begets financial distress. The primary element of randomness that makes insurance work is violated. It's going to be interesting to see how it plays out in the next downturn.

CDS do add to volatilty. Delphi is a good example. Before Delphi defaulted a couple of years ago, the notional value of the CDS written on Delphi debt far exceeded the par value of the Delphi debt outstanding. Perversely, when Delphi finally filed for bankrtupty, the value of Delphi's bonds actually spiked. Did they spike because the debt had suddenly become more valuable upon the bankruptcy filing? No, they spiked because many of the writers of the credit default swaps bought the bonds in the open market at a discount to par rather than risk having the credit default swaps assigned to them at par.

[CrazyAce]

Thanks guys, you've answered my question and more

[Hellrazor]

[ QUOTE ]


[/ QUOTE ] are there options on corporate debt? thats a good way to bet on bankruptcy i think if it were feasible, buy OTM puts on the debt if you think there is a larger than priced in chance the corporation will file chapter 11.

[/ QUOTE ]

Yes. They're called credit default swaps. All the big investment banks make a market in them. It's a non-transparent, very lightly regulated market making it nearly impossible to know who owns them, who has written them, or whether or not the writer of the option will be willing and able to perform in the event of a credit default. They trade over the counter and don't go through an option clearing house, so it's really the wild west.

In the benign credit environment of the recent past, writing credit default swaps has been like free money. Hedge funds have approached them like insurance, belieiving that if they write CDS on a large number of creditors, the premia from the issuers who don't default will cover their obligations against the few that do after recovery. They certainly have super sophisticated models to assess value at risk, but it's really a grand untested experiment. My feeling is that adverse events in insurance happen more or less randomly. For example, if a neighbors house 3 blocks aways accidently catches on fire, there's no reason to think my house will accidently catch fire. But when an economy turns down, financial distress begets financial distress. The primary element of randomness that makes insurance work is violated. It's going to be interesting to see how it plays out in the next downturn.

CDS do add to volatilty. Delphi is a good example. Before Delphi defaulted a couple of years ago, the notional value of the CDS written on Delphi debt far exceeded the par value of the Delphi debt outstanding. Perversely, when Delphi finally filed for bankrtupty, the value of Delphi's bonds actually spiked. Did they spike because the debt had suddenly become more valuable upon the bankruptcy filing? No, they spiked because many of the writers of the credit default swaps bought the bonds in the open market at a discount to par rather than risk having the credit default swaps assigned to them at par.

[/ QUOTE ]

While you're correct that one way to bet on banruptcy is to buy a CDS, you're way off on the spike in delphi prices being attributed to sellers of CDS buying up bonds at a discount. Delphi was mostly "cash settled" where bonds/loans were not delivered to be paid back at par but rather an auction was held to determine the accepted recovery rate and coverage was paid back based upon that. (I am sure some were physically settled still but not anywhere near the gross notional amount of CDS outstanding)

Also, it's important to note that there are many "tear-ups" when there is a Credit Event so that most dealers (and some client side as well) net down position pretty well and only a small fraction of outstanding CDS coverage is actually settled when a credit event occurs.

Also there are practically zero private investors who have CDS. Lastly while CDS are still mainly unregulated - the Fed and FSA have taken a big interest and require regluar reporting on CDS from the major broker dealers who in turn have asked clients to comply with various iniatives to add control to the market. As for no clearing house - check with DTC on that- the DTCC wharehouse will hold almost all (live) CDS trades (more than half of all current trading is confirmed through there and it is a Fed and FSA mandate to get the % clearing through DTCC (a part of DTC) to be at a very high rate.

[DespotInExile]

[ QUOTE ]
whats the relative price volatility of corporate debt after a chapter 11 files? i'd think it would rise significantly.

[/ QUOTE ]

This depends entirely on the pre-filing capital structure of the entity, and whether in a reorganization, you're above or below the cramdown/pivot security.

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
whats the relative price volatility of corporate debt after a chapter 11 files? i'd think it would rise significantly.

[/ QUOTE ]

This depends entirely on the pre-filing capital structure of the entity, and whether in a reorganization, you're above or below the cramdown/pivot security.

[/ QUOTE ]

what is a cramdown/pivot security? is that the security that is in between the first lein creditors and the bondholders? probably not since that is a guess outta my ass but i am curious as to how that goes down.

no pun.

thanks,
Barron