Magellan Health Services

• Stephen Moyer, an experienced distressed-debt investor, wrote a book on the subject with the case study of Magellan Health Services. Magellan offers a range of psychology-related insurance policies as a specialty subcontractor of full-service plans such as Blue Cross/Blue Shield.
  
  Magellan encountered troubles in 2002 and 2003. It lost a major contract with the state of Tennessee, for example. It also fell behind on an information technology update and integration project. Other problems piled on top of those, and in May 2003, Magellan filed for Chapter 11 bankruptcy protection.
  
  

Magellan's Subordinated Debt

• Magellan's debt outstanding included $625 million on subordinated notes, meaning they could not be paid off until other more senior debt had been paid in full.
  
  In October 2002, several months before the bankruptcy filing, the value of these subordinated notes in the secondary market had fallen to 22 percent of their face value.
  
  Once Magellan was in Chapter 11, it became clear to the market that the company was in essence sound and that the notes would indeed prove valuable. Moyer reports that a "bidding war of sorts broke out" by May.
  
  The company was reorganized in January 2004, and those who had bought the subordinated notes became owners of the equity of the new company.
  
  A speculator who had bought the notes at their low point, in October, and who had held on until receiving that equity and sold into the market could have received a return on investment of 231 percent.
  
  

Caution

• The Magellan case as presented above is a best-case scenario. Sometimes an investor, even one who has done a conscientious analysis, will buy debt he believes has been thoroughly discounted, expected such a recovery -- and the price of the instruments involved will continue to fall, perhaps going to zero.
  
  As another experienced investor in the field, Howard Marks, has noted, no investment is "good or bad intrinsically." Everything depends on timing and price.
  
  

The Five Cs

• Some analysts talk about the so-called "5 Cs" of credit: character, capacity, capital, conditions and collateral.
  
  The character of a firm consists of its leadership, strategy, and reputation. If the character is in place it may have the capacity to make enough money to pay off its debts. But somebody must be ready to stake the capital necessary for a turnaround. The environment of the firm, its competition and the macroeconomic situation, is called the "conditions." Finally, collateral security may buoy the prospects of repayment.