2 Junk Bonds Worth the Risk

08/26/2011 8:30 am EST

Focus: BONDS

Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

The massive sell-off in equities took down the high-yield market with it. Finally, junk bonds pulled back, and it’s now time to buy, says Marilyn Cohen of Bond Smart Investor.

Our corporate bond risks for the remaining months of 2011 are mergers & acquisitions, takeovers, special dividend payouts, increased dividends, and all the awful balance-sheet shenanigans we have seen bad management make in previous cycles. But with a weakening economy, CEO’s are less likely to squander their cash.

Tesoro Corporation (TSO), an oil-refining and petroleum-products company, is improving by the day. Their financials are looking better and the balance sheet is improving. Management can’t take the credit—there’s been a global refining upswing.

Look at Tesoro’s numbers: Its EBITDA was $1.02 billion on March 31, versus $661 million in 2010, versus $443 million in 2009.

Ooh la la! The numbers and their direction are all encouraging. With a total of $1.7 billion in cash, equivalents, and revolver availability, Tesoro can manage its next maturing bond issue—$450 million, due next year.

Certainly, a stagnant economy can and will hurt Tesoro, as well as other refiners. The list of what can go wrong is pretty standard: More regulations; biofuels mandate; refineries operating in California; emissions standards—all the usual suspects.

Tesoro 6.50% notes due June 1, 2017 (CUSIP: 881609AT8) are callable beginning June 1, 2012 at 103.25.

All Tesoro’s bonds have Change of Control provisions for bondholders (please see my recent Forbes.com blog to read more about these provisions).

But the bond indenture also has a “Fall Away Covenant.” That means that if Tesoro’s ratings rise from junk to investment grade, then the company’s Change of Control put asset sales, lien restrictions, and restrictions on payments all are cancelled.

And, if at any time Tesoro’s ratings fall back below investment grade, none of the Change of Control protections bondholders previously had are reinstated. Having said all that, Tesoro is still a decent buy.

Smithfield Foods, Inc (SFD) is easy to understand and relate to. It processes and markets pork products under 50 different, nationally recognized brands.

Smithfield’s distribution network is via wholesalers, catalogs, the Internet, and retailers. The industry is a low margin, volume business. Smithfield’s credit metrics have improved, and as of May 1, the company had $375 million in cash and $900 million in available revolver credit.

Smithfield is the largest hog producer and pork processor globally. The company has $12.2 billion in annual sales—not a mom and pop operation by any means.

Did you ever buy Boar’s Head ham or turkey? Ever pack LunchMakers for your kids? Both are Smithfield brands, to name just two. The company has three operating divisions: Pork, International, and Hog Production.

What really entices me about Smithfield’s is that the company has reduced debt and has free cash flow. If you like packaged meats, you may like Smithfield’s bonds.

Smithfield 7.75% notes due July 1, 2017 (CUSIP: 832248AQ1) are non-callable.

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