Reading 2022-06-28


  • Ref:: Bloomberg
  • Title:: Expensive Stocks Make for Good Bonds
  • Author:: Matt Levine
  • Year of publication:: 2018
  • Category:: Blog
  • Topic::
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Notes from reading

Netflix Theory, a half-joking name for the idea that a company should be able to issue debt cheaply, even with limited assets and cash flows, as long as it has a big enough equity market capitalization. Some possible explanations for this theory: that the companies could always raise new equity to pay off the debt, or just the efficient-markets explanation that if shareholders valued the company so highly that must mean that it really has plenty of assets or cash-flow generation.

One good argument for Netflix Theory. That argument is basically that Netflix Theory is just a dumb name for “capital-structure arbitrage.” The simplest form of this is:

  • If a company has a big equity market cap and relatively high-yielding debt, you can buy the debt and short the equity and bet on convergence: If the company ends up doing well and making a lot of money, your debt will pay off (and you’ll get paid some excess spread for buying high-yielding junky-looking debt that turns out to be money-good, subsidizing your losses on the short); if it ends up doing poorly and losing money, the stock will go down and your short will pay off.
  • Or a refined version: If a company has a big equity market cap and relatively high-yielding debt, you can buy the debt and use a portion of your excess yield to buy deep out-of-the-money put options on its stock. In most states of the world, the debt will pay off and you’ll lose your option premium (but still do fine because you only used a portion of your excess yield). But if everything goes wrong for the company and it defaults on its debt, its stock will crash and those puts will be worth a lot of money, enough (if you size the trades right) to cover your losses on the debt.

Take Netflix Inc. It closed on Friday at $309.10. If you own $30 million of Netflix bonds, and you want to hedge them against default, you could buy one-year put options on 1 million shares of Netflix with a $30 strike price. If Netflix defaults on its debt then the stock should be worth zero, which means your puts will be worth $30 million. But because Netflix is worth $309.10 today, and the puts are so far out of the money, they should be very cheap today. Just dumbly using Bloomberg’s Black-Scholes calculator, I get a price of a bit less than a penny per share, or about $8,000 for the lot of them. Meanwhile Netflix sold 10-year bonds last week at a 6.375 percent yield, meaning that you get paid about $1.9 million per year in interest on your bonds. Eight thousand a year for the puts is nothing.