KKR inquiry into a bathroom remodel gets blown out of proportion

Rumors are swirling that Home Depot is in the sights of private equity buyers, and that the bid might not be friendly. While Home Depot stock was only up marginally yesterday, the bonds were getting killed. HD '16's were trading in the +75 range last week, now over +100.

In many ways, a buyout makes some sense. First, you've got a languishing stock. Weighing on Home Depot stock is obviously the housing situation, but the stock had been languishing before this year. There are questions about management, highlighted by the near riot at the most recent annual meeting. If a private equity buyer could wait out the housing downturn and remove the current management group, they might earn a nice profit.

On the other hand, this would be an extremely large transaction, likely over $100 billion. I'm also surprised to hear this deal might be done as a hostile take over. I can't think of any major private equity deals done recently as hostile. I'm sure there was one or two, but not any of the really big deals.

Does that make Home Depot bonds a buy? There are two likely paths for this bond. If there is no buyout, the bonds probably tighten to +80 to +85. They won't make it all the way back to +75 because there will remain this lingering doubt over whether the buyout idea could come back.

If there is an LBO, the bonds could go out another 100-200bps. It all depends on what the new company looks like, which we can't know at this point. Given that Home Depot is rated Aa3/AA, so if they were to move into junk territory, +300 or so, that's +200 from here.

So you have 15-20bps of tightening potential and 200bps of widening potential. In percentage terms, that's upside of around 1.5% and downside of 16%. Some investors would stop right there, unwilling to take risk that is so negatively skewed. But for traders it becomes a question of odds. If you think the odds of the buyout actually coming to fruition is 1%, its a buy. If its 10%, its a push. If its 20%, its a short-sell.

For my money, there are plenty of A-rated corporate names with a little hair on them that have 15bps of tightening potential and offer better odds against widening.