dankner - Moti Kimche - September 14 2011
Nochi Dankner. Photo by Moti Kimche
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During the last two days, the public's faith that the IDB group will honor its debt has been scratched. Yields on bonds issued by IDB group companies soared to junk territory, as the market puts it. In other words investors suspect that IDB, the biggest holdings company in the land, may not repay its debt in full: Therefore, investors are demanding higher returns for the privilege of investing in its bonds.

Whence the dubiety?

The reason is that too many factors in the financial field are playing against IDB at this point in time. There's the crisis in Europe: IDB invested billions of shekels in the Swiss bank Credit Suisse. There's the crisis in the United States. There's the social upheaval in Israel, leading to endless committees and boycotts which threaten profits at IDB group companies Super-Sol, mobile operator Cellcom, cement producer Nesher and others. The upshot is diminished cash flow and therefore, diminished capacity to repay debt. And there's another reason: Investors' faith in the management talents in the group may have been shaken. They may wonder whether the management headed by Nochi Dankner will indeed pilot the ship to safety.

In capital market circles, when crisis strikes and bond prices tank, matters become even worse. When bond prices are low and yields on the bonds (which behave inversely to price ) rise, then the company's cost of borrowing rises, making it harder to refinance its debt. In other words, it's a snowball barreling down the mountainside.

Yet possibly the market has been a tad harsh with IDB.

Note that investment in its bonds, at this point, will give the investor annual returns linked to the consumer price index of 11% to 18%. In other words, assuming Dankner does repay his debt in full, investors will double their money in five years.

The danger in this scenario is that like Lev Leviev at Africa Israel Investments, Dankner could decide to give his bondholders a haircut - not repay them in full.

There is a way, for the market savvy, to have their Dankner cake and eat it too - invest while reducing risk. A private investor can't do what I describe here, but would do well to understand the market failure I describe.

First of all, let's assume that consummation of the sale of Makhteshim-Agan Industries to the China National Chemical Corporation will allow IDB and Koor to repay their bondholders almost in full. The deadline for that deal is the end of October.

At that time Koor will get $1.1 billion. Against its debt of NIS 4.7 billion, it will get the NIS 4 billion in cash from selling Makhteshim-Agan. It still owns 2.2% of Credit Suisse's stock, and can rack up NIS 700 million from other sources, including half the HSBC headquarters in Manhattan and the Epsilon investments house. In other words, it would have NIS 2.3 billion left.

Now, if ChemChina cancels or delays buying Makhteshim-Agan, then Makhteshim-Agan stock would fall hard and IDB's financial situation would be worse. But while IDB group bond prices signal trouble ahead for the Makhteshim-Agan deal, Makhteshim-Agan stock is trading as though the deal is done. In fact it's one of the only stocks to make money for investors this year - it's gained 53% in the last 12 months.

In short, the bonds say no deal. The stock says yes deal. What can one do? One can hedge, long on Koor or IDB bonds and short on Makhteshim-Agan. (Short selling means that one borrows the shares, sells them to somebody else, and when you have to return the shares you buy them on the market. You're gambling that the share price will fall. )

Now all that remains is to study the two possible scenarios and their effect on that strategy.

1. The Makhteshim-Agan deal falls through, or its terms change for the worse.

IDB's situation: It would have difficulty repaying bonds in time.

Market reaction: Makhteshim-Agan stock tumbles, Koor and IDB group bonds fall hard too.

The state of the investor who hedged as suggested: Profit from Makhteshim-Agan's fall, loss from bonds' fall: Even.

2. The Makhteshim-Agan deal closes:

IDB's situation: With the $1.1 billion influx, it would repay its bonds in time.

Market reaction: Makhteshim-Agan stock doesn't move. Koor and IDB group bonds shoot up.

The state of the investor who hedged as suggested: No damage from going short on Makhteshim-Agan, profit from bonds.

Now all that remains is to hope that Nochi Dankner, who apparently knows that the Makhteshim-Agan deal is the key, will come back from China with good news.