Roger Lowenstein, in his preface commentary found prior to Chapter 1 of Security Analysis, wrote:



“In the 1930s, there was a common notion that bonds were safe— suitable for ‘investment’—while stocks were unsafe. Graham and Dodd rejected this mechanical rule, as they did, more generally, the notion of relying on the form of any security. They recognized that the various issues in the corporate food chain (senior bonds, junior debt, preferred stock, and common) were not so much dissimilar but rather part of a continuum. And though a bondholder, it is true, has an economic, and also a legal, priority over a stockholder, it is not the contractual obligation that provides safety to the bondholder, the authors pointed out, but ‘the ability of the debtor corporation to meet its obligations.’ And it follows that (leaving aside the tax shield provided from interest expense) the bondholder’s claim cannot be worth more than the company’s net worth would be to an owner who held it free and clear of debt.”



This reality is one of the reasons why I own no general corporate bonds. A general unsecured bondholder has certain contractual returns (i.e. priority over the stockholders) that creates a higher probability that a company will meet its obligations to the bondowner. But, in recent years, as businesses have switched to maximizing the short-term value of its capital, nearly all assets have become pledged and many assets that used to be owned outright by companies (even general office accoutrements like printers and copiers) are now rented.

As a consequence, general unsecured debt of a corporation does not provide the same balance sheet assets for meeting its assets as was historically the case.



Take a company like Domino’s. It carries $3.5 billion in debt. About $1.5 billion of that debt is securitized–i.e. the creditor provided Domino’s money in exchange for a secured interest in a specific piece of property like the real estate, ovens and other fixtures, or even the Domino’s trade name.



If Domino’s were to incur a liquidation event, there would be about $550 million in Domino’s liquidated net worth that would be available after the secured creditors received payment (technically, this figure could be higher or lower depending upon the ultimate sale value of the securitized debt, and Domino’s does not disclose this because it is not legally required to do so).



This means that if someone buys one of those Domino’s general corporate bonds yielding 3% or 4%, the terms are really something like this: “You will collect 3-4% on your investment until the date of maturity at which point your principal will be returned so long as Domino’s remains a solvent, going concern. If Domino’s collapses, there will be about $2 billion in unsecured general corporate creditors entitled to the remaining $550 million, which means you’d get $275 back on every $1000 invested.”



Personally, I would not even rely upon this return of twenty-seven cents on the dollars during a distress event because corporate debtors can continue to pledge assets to the detriment of unsecured general creditors under the terms of its debt covenants (in contrast, some general creditors, such as the bondholders of Niemann Marcus, have a clause in their debt covenants that requires their 75% approval of any asset that Niemann Marcus attempts to securitize while their general unsecured bonds remain outstanding).



This means that, if, say, Domino’s were to collapse, it would almost certainly burn through the $84 million in cash currently on the balance sheet and the $41 million in inventory that is not currently a securitized asset would be borrowed against. Well, this knocks down the assets to $429 million, and you’re down from twenty-seven cents on the dollar to twenty-one cents on the dollar.



For a 3-4% return, with no additional possible upside to that, the likelihood of being able to recover about 20% of your principal in the event of a bankruptcy scenario is not my idea of compelling comfort.



My own view is that, if you want cash and liquidity, stick to cash and U.S. treasuries, and keep your eye on the lookout for highly unusual events like U.S. bonds yielding 11% in the early ‘80s, small U.S. bank bonds yielding 9% in the early 1990s, and even oil supermajor bonds briefly yielding 7% during the last cycle’s lows. I think the default assumption should be that general corporate bonds won’t protect your principal, and should only be bought when the yield is higher than typical, the business has a high likelihood of remaining solvent, and the bond covenants for the general unsecured creditors require their approval before any assets are pledged to someone else, all with the probability that at least half of the bond value could be repaid in the event of bankruptcy. These situations are hard to find in ordinary or even favorable economic conditions, and hence, I don’t own any.

