Doomsday Scenario The Risk of Corporate Bankruptcy

Corporate bankruptcy is a major underlying risk associated with every single security in an investor’s portfolio. However, it is only really the fixed-income holders that take it seriously. While this is likely due to the way in which bonds and preferred shares have fewer other risks to distract from the less likely threat of default, it remains an important consideration.

Think back to Citibank as an investment between 2007-2009, where its share price dropped from $550, all the way down to $15, surely investors were considering insolvency as a serious risk as subprime losses destroyed their holdings, but yet somebody was still purchasing. In fact, I have a friend that made a great deal of money on Citibank during that same period (no, they weren’t short-selling). How? They considered the risks for what they were, and they reacted appropriately. Here’s how it works.

There are a number of ways to protect a position from corporate bankruptcy. Ignoring responses such as diversification, my personal favourite is to completely hedge the value of a position through the use of derivatives. I’ll find a position I’m interest in, and take a moment to consider how much money I have available to me at any given time. If I have an excess of capital available to me, or if the stock pays a respectable dividend, I will purchase it, and then allocate an offsetting amount by purchasing put options that are far out of the money.

I will either price these options by considering them as a fee taken out of the dividend, or as being simply an insurance measure against collapse. While the cost of this insurance is fairly low, it can provide me with about a year’s worth of safety against a complete collapse of the share price. What’s more, it is sometimes (though rarely) possible for me to recoup an amount of my offsetting position, assuming the stock has simply remained stagnant. Lastly, the amount I’ve paid for my insurance is fairly cheap, and so it doesn’t do much to limit my upside potential, in the event the stock should go for a bull-run (such as would happen if the company managed to unexpectedly mitigate the short-term risk of insolvency).

Another strategy that an investor might use combines the diversification of a mutual fund with the sophistication of a stock picker. Suppose a personal investor is holding a passive mutual fund that holds XYZ stock during a fairly shaky period. Specifically, XYZ’s staff is on a major strike, the management has quit, and the company is subject to fraud allegations. Even if the mutual fund has diversified this holding to being less than 1% of its holdings, that position will still have a material impact on the fund’s performance.

Given that the fund will not likely be able to liquidate its massive position in XYZ until some time has passed, your portfolio is exposed to XYZ whether you like it or not. What’s the solution? You could consider taking matters into your own hands and short the XYZ stock, with the assumption that: If it collapses, my short will cover the value of my mutual fund position, while if it increases, my mutual fund position will dilute my losses on the short to the point at which they are immaterial. Another option would be similar to as above, in that you could purchase a small put position on XYZ itself over the short-term (while the fund dumps its position).

This second method is favourable, because it provides you with the company-specific hedge, while also limiting your exposure (purchasing a put does not require you to engage in any transactions, allowing you to maintain flexibility), and also allowing you limited down-side risk. Lastly, you are in the benefit of knowing that your fund will be selling off its position in XYZ as soon as you are informed by the manager of such actions. This does not constitute insider information (unless the document from the manager indicates otherwise), because the fund will have also made it clear to the market that it is doing so.

While the risk of corporate bankruptcy is fairly minor, mainly because a good investment advisor will always be there to help you screen companies for quality, it is important to recognize that a personal investor is not powerless against it in the event that it should become a material threat. With that in mind, I’ll progress to a much more intense level of dooms-day threat in the next posting of this series, as I discuss the risk of a full blown bankruptcy from a municipality, state, or even a country.