Lessons Learned‏

Today Sirius XM radio (SIRI) was saved from bankruptcy by a supposed White Knight investor in Liberty Media Corp. (LCAPB). Because of the current credit crisis, Sirius XM was unable to refinance some of their debt obligations that were coming due this year.  While this current infusion of capital is a short-term solution, the story behind these events has a very interesting lesson.

On the face of it, if you had a crystal ball and bought shares of Sirius XM’s common stock last week, you’d have a 50+% gain on your hands and be a stock market genius.  The large rise in price is due to the subsiding fears that the company would declare bankruptcy if they couldn’t meet their $172 million debt obligation due today.  So, if the last-minute financing had failed to come through then the short sellers would’ve been right and Sirius XM’s shares would be near worthless when they went into Chapter 11 bankruptcy.  That’s the high-risk of bottom fishing for companies in this market.  Common stockholders are the last ones paid off in bankruptcy, so they’re assumed to be holding onto worthless paper in the end.  But what can you do to lower your risk?

Well, if we get back to the example of Sirius XM, you could take the position that Echostar went into when the debt payments were coming due.  By buying the actual corporate debt or preferred shares, you can hedge yourself against the risk of losing everything to bankruptcy.  By buying up the corporate debt on the cheap, Echostar was able to log a modest profit even though the original debt issue matured at 2.5% because they were able to purchase it at far below the original cost.  And while Echostar was buying up the debt to gain assets in a Chapter 11 bankruptcy proceeding as a preferred debt holder, an individual’s investment in the debt would also have not been entirely wiped out like common stockholders.

So what can be learned from this example?  If you want to take a risk on a company that may have large debts coming to term, there are other options besides common stock.  Find preferred stock and debt that has been beaten down due to the bankruptcy fears.  If the company is able to meet its obligations, a quick and tidy profit will be made.  And if not, at least you will not be able to retain some of your initial investment  Preferred stock is also a good option to consider during more normal times since they retain their value far better than the rest of the market while paying higher dividends than common stock.

Disclosure: I have current ownership in Sirius XM.

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