Capital-structure arbitrage

Capital-structure arbitrage is a strategy of simultaneously trading a company’s stock and bonds (or other capital-structure instruments) to exploit relative mispricings. The arbitrageur bets that when equity and debt are mispriced relative to each other, their values will converge.

The capital-structure opportunity

A company’s stock and bonds are claims on the same underlying business, but with different seniority:

• Bonds are senior claims; creditors are paid before shareholders.
• Stocks are residual claims; shareholders get what is left after all creditors are paid.

When a company is in financial distress:

• Bonds may trade at 60 cents per dollar (implying a 40% default probability).
• Stocks may trade at low valuations but still assume the company survives.
• A capital-structure arbitrageur might bet that: (1) the company will survive (stocks are cheap), or (2) the company will default (bonds are overpriced and equities worthless).

The trade

Scenario: A distressed retailer’s bonds yield 10% (implying 5% annual default risk). Its stock has crashed from $20 to $2, implying severe distress. However, analysis suggests the company can survive with restructuring.

The trade:

• Long stock at $2 (betting on survival and recovery).
• Short bonds at 80 cents per dollar (betting that bonds are overpriced given survival odds).

Outcome 1: Company restructures and survives. Stock rallies to $8; bonds recover to 95. The arbitrageur profits on both legs.

Outcome 2: Company defaults. Stock goes to $0; bonds recover 50% in bankruptcy. The arbitrageur loses on stock but gains on short bonds, partially offsetting.

Challenges

1. Seniority and recovery. If the company defaults, bond recovery and stock recovery depend on asset sales, bankruptcy process, and other factors. Models are complex and uncertain.
2. Timing. A company can remain insolvent (or solvent) for far longer than predicted. Carrying costs erode returns.
3. Liquidity. Bond markets are less liquid than equity markets. Exiting large bond positions is difficult.
4. Correlation breakdown. During crises, stock-bond correlations can diverge dramatically, causing hedge misfires.

See also