Finding Value in Bankruptcy: Understanding the Role of Bonds and Debt

It all started at the airport. I was on my way to New York City, and like many travelers, my flight was delayed. I found myself sitting next to two guys who were clearly deep in discussion, their eyes glued to a Bloomberg terminal on their tablet. I couldn't help but notice the logos on their jackets—logos of a very reputable hedge fund that I'd heard of before. I leaned back, trying not to eavesdrop too obviously, but their conversation was too interesting to ignore.

They were talking about a bankruptcy case, digging into the details of the company's capital structure. They were dissecting bonds, secured debts, and laying out different scenarios of what could happen—every detail covered with a level of thoroughness that made it clear these guys knew what they were doing. It wasn't just casual chat; it was the kind of discussion that can only come from experience and deep knowledge. I was impressed, intrigued, and frankly, a bit fascinated.

That conversation stuck with me. After I finally made it to New York, I couldn't get it out of my head. I started researching, reading books, and diving into the world of bankruptcy investing—particularly focusing on bonds and debt instruments. Eventually, I even reached out to those two fund managers, and we’ve stayed in touch ever since. They opened my eyes to a whole new side of investing—one where value hides in places most people don’t even bother to look.

When a company files for bankruptcy, it might seem like the end of the road. Stockholders typically panic, and the common stock often becomes worthless. However, for those willing to dig deeper, there are often opportunities within the capital structure that are far less risky and potentially quite rewarding. This is where bonds and debt come into play. Unlike common stock, bonds and certain other debt instruments have senior claims on the company's assets—meaning they are more likely to get paid back if the company manages to restructure or liquidate.

One of my first deep dives into this world involved a retail giant—J.C. Penney. In 2020, as the pandemic ravaged traditional retail, J.C. Penney filed for Chapter 11 bankruptcy. It was clear that the common stock was unlikely to recover, but the company had issued secured bonds that were trading at a deep discount. These bonds had a claim on valuable assets, such as real estate and inventory, giving them a layer of protection that the common shareholders didn’t have.

At the time, J.C. Penney’s secured bonds were trading at around 35 cents on the dollar. After analyzing the company’s restructuring plan, I estimated that the liquidation value of their real estate assets alone would cover a significant portion of these bonds. It wasn’t without risk, but I saw the potential upside. Ultimately, when J.C. Penney was acquired by a group of mall operators, the secured bondholders ended up receiving a significant recovery, while the common shareholders were wiped out. It was a powerful reminder of why understanding the capital structure is key to investing in distressed situations.

Bankruptcy investing isn’t just about looking for the most beaten-down asset; it’s about understanding where you stand in line when it comes to getting paid. Bonds, especially secured bonds, are often at the front of that line. These are bonds backed by specific assets, like property, equipment, or other collateral. This backing makes them much less risky compared to unsecured debt or equity, which means that in a restructuring or liquidation, you’re likely to get something back.

Another example that comes to mind is Hertz Global Holdings. Hertz filed for bankruptcy in mid-2020, caught in the tidal wave of collapsing travel demand. Most investors stayed away, thinking the situation was too risky, but those who understood the debt structure saw a unique opportunity. Hertz had issued asset-backed securities tied to its fleet of rental cars. During the bankruptcy, it became clear that the value of the underlying assets—the cars themselves—was significantly higher than what the market initially assumed, thanks to a spike in used car prices. Investors who bought Hertz’s bonds at a discount ended up with substantial gains as the company managed to restructure and eventually emerge from bankruptcy in a much stronger position.

The lesson here is that bankruptcy doesn’t always mean doom and gloom for all stakeholders. Debt holders—especially those holding secured or senior debt—often come out ahead, even when the equity holders get wiped out. The key is to carefully evaluate the underlying assets and determine whether they are likely to retain enough value to cover the debts.

So, what should you look for if you want to explore this type of investing? Here are a few key points:

1. Understand the Capital Structure: Not all debt is created equal. Secured bonds have collateral backing, while unsecured bonds are more like IOUs without specific assets tied to them. Always know where your potential investment sits in the capital hierarchy.

2. Evaluate the Assets: In a bankruptcy scenario, the value of a company’s assets is what will determine whether debt holders get paid. Look at the company’s real estate, inventory, intellectual property, or other tangible assets. For example, when analyzing J.C. Penney, it was the real estate that provided security for the bonds.

3. Look for Forced Selling: Many institutional investors have mandates that don’t allow them to hold distressed or bankrupt securities. This often leads to forced selling, which can create opportunities for those willing to take on the risk. Bonds that were once trading at face value can suddenly be available at 20 or 30 cents on the dollar.

4. Be Patient and Cautious: Bankruptcy processes take time, and they are often complex. You need patience to see the investment through, and you should always be cautious about the risks involved. Not every distressed company will recover, so it's crucial to do thorough research.

   
   

One more recent example is PG&E (Pacific Gas and Electric Company), which filed for bankruptcy in 2019 after facing massive liabilities from California wildfires. During the restructuring, PG&E's bonds traded at steep discounts, but those who understood the company’s underlying utility assets and the critical nature of its business saw an opportunity. The company emerged from bankruptcy in 2020, and many of its bondholders saw substantial recoveries, while equity holders faced much more uncertainty.

Investing in bankruptcies isn’t for everyone—it requires a willingness to do deep research and a tolerance for risk. But for those who are willing to look beyond the headlines and understand the nuances of debt and capital structures, there can be significant opportunities. Bonds and other forms of debt can offer a way to invest in distressed companies with a margin of safety that common stock simply doesn’t provide.

So, the next time you hear about a high-profile bankruptcy, don’t just write it off as a lost cause. Dig into the details, understand the capital stack, and see if there’s an opportunity hidden in the bonds or debt instruments. You might just find that what others see as the end of the road is actually the beginning of a rewarding journey.