Hi - I was hoping someone can help me understand the following:How is it that under certain circumstances, a senior bond can be trading at say 50 and sub at 20, and yet you have equity trading at say 12 cents per share? Why does the equity have any value at all - given that bond holders are to be paid in full before equity owners receive any amount?
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Option value
I am not sure what you mean by “option value”. In the case where senior bonds are trading at 50, and subs 20, what option would an equity holder truly have? Wouldn’t the value be 0 regardless of whatever option you are able to exercise?
It’s an option in the sense of it could go to 0 (already near there so relatively little downside from current levels) or to the moon in a full rebound. Anything can happen (infinite monkey theorem).
Look at the major bankrupt car rental company today. Unsecured notes are trading sub 50, which implies they’re impaired, and the equity is at de minimis levels. However, today, no one can definitely say that it’s a 0. Valuation becomes a focus point in the case later on and only then will we be able to definitely give an answer. Today, it’s an (albeit unlikely) option on the equity.
The equity essentially has call option value. While the equity would be wiped out to any meaningful degree if either of the valuations implied by the senior or subs came to fruition, there’s a very (very X 10) slight chance that a major turnaround event occurs, be it industry-wide or company-specific, or maybe some rich person decides to inject an immense amount of life saving equity.
Assuming said turnaround does occur, wouldn’t that happen post reorg? At which point subs become the new equity holders.
In practice, no one buys deeply deeply subordinated securities for "option value" even though that is the academic question.
The actual reason, why you see all these random bankruptcy stocks trading for more than a penny, is because there are buyer and sellers of said security making a market because they don't know any better. Call it Robinhood or retail fever, or very wide bid asks that brokers quote on an eventually zero volume security. Deeply subordinated bonds with no buyers or sellers usually trade down to a penny or less on almost no volume.
Yes they become illiquid. Stubborn people will still hold though. Look up Ackman with some of his losses lol
Also, not mentioned above, depending on the how the restructuring is negotiated/structured the equity might get something just to make it an easier process. Maybe like 0.25-1% of post reorg equity. Granted people doing the trading probably aren't thinking about this, it nonetheless happens.
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