November 30, 2008

Value Idea: Junk Bonds

There is more deep value in debt instruments than equities. Debt at these yields will give you more than adequate returns with a good margin of safety than equities. In the pecking order of bankruptcies, corporate bonds, even high yield, come
before the equity holders. Some consider equities to be the butt of the investing world, as they rank at the bottom of every body else.

In this post I want to focus on Junk or high yield bonds, a more politically correct term after the Drexel fiasco in the 1980s.

Junk bond values reached a historic peak (measured by the narrowness of the spread between junk yields and Treasury bond yields) in June 2007, when they bottomed out at 268 basis points over Treasuries. In the past six months, spreads have doubled, to 1800 basis points. The default rate for high-yield bonds has also been at historical lows of 3%. Currently Junk bonds sell for 60 cents to the dollar.

However, as the economy settling in to what seems a deep and long rescission defaults will spike and could reach up to 17%. At current levels, the market is pricing in a rise in defaults from
3.4% now to 15%-20% as the economy and corporate profits continue to slacken with no end in sight. The record default rate was 15.4% way back in 1933, again during the -- you guessed it -- Great Depression.

To give you an idea of the scale, the default rate in 1933 was 15.4%; in the early 1990s recession, it reached 12%. These are still far in the distance. Over the year to the end of October, only 2.9% of American junk bonds had defaulted, according to Standard & Poor’s (S&P). It expects the rate will rise to 7.6% by September 2009 (or 9.6% if the economy tumbles).

The case for High Yield:
  • Junk yields are high enough that even if defaults hit Depression-era levels, the bonds should beat Treasuries over the coming years.
  • Inter bank lending rates have moved lower so did mortgage rates. You can argue that these are prelude to reduced lending rate for corporate borrowing. If so then you will see meaningful recovery in prices.
  • The market is pricing an unprecedented default rate of 20%; it may be right. But if it's too pessimistic, the long-term payoff in junk bond mutual funds could be tremendous at these prices and yields.
  • As corporations delver and rebuild balance sheets,the best use of corporate cash now may be to buy back bonds at discounts, effectively discharging debt for pennies on the dollar.
  • Recovery rate: When talking about default rates, one has to mention recovery rates. The standard assumption, historical average, is that the recovery rate will be 40%.
The Case against High Yield Bonds:
  • The deleveraging in debt is occurring at an unprecedented level so when the market prices unprecedented 20% default rate, that may be warranted.
  • Can debt maturity be refinanced? With governments also likely to tap the debt markets heavily, investors may be worried about the prospect of their portfolios being weighed
    down by fixed-income assets.
  • Higher rates lead companies to cut back on borrowing. A drop in borrowing typically means less corporate spending and sales growth, another reason why companies won't earn as much money and stock prices will stay low and the credit metrics of borrowers will deteriorate further.
  • In the past decade hedge fund supplied the high yield market now hedge funds are being squeezed by redemption so who will supply companies with cash in exchange for yield.
  • We are in a negative reinforcing cycle that will take some time to be broken. High borrowing cost will prevent companies from rolling their maturing debt forcing more defaults, as more debt defaults junk bond yields will go higher preventing companies from borrowings and defaulting on maturing debt, and so on. Until borrowing costs come down to levels that will make economic sense to businesses, default will move higher and junk bonds will decline in value.
  • The higher the default rates the lower recoveries will be so the standard 40% recover may not be realized. A recovery rate closer to 25% or lower may be more like it. Case in point in 2002 when defaults reached 13% recovery rates turned to be well below the average, actually it was 25%.
  • Default rates can shoot beyond the trough of the business cycle.
In order to make the case for or against high yield bonds, I am going to do a simple stress test. I have the following assumptions:
  • The average high yield bond trading about 61 cents to the dollar,
  • 15% default rate (Please note that default rates will never jump to 15% from its level of 4%. A more realistic scenario for default rates is to ramp up to the 15% mark and that could take a year or more, but for simplicity, I will assume they will jump immediately to the 15%)
  • 40% recovery rate from defaulted bonds.
  • 5 year investment horizon
Given these parameters you will achieve 14% Internal Rate of Return (IRR). That's pretty good. even if we assume a more of dramatic default rates of 20% and recovery rate of 40% then the IRR would drop to 11.5%. Actually if we perform various scenarios of default and recovery rates we come with the following IRR outcomes:

Default %
Recovery rate%


Those returns are enabled by the low price you pay for high yield bonds. Just remember that the price you pay is the major determining factor of expected returns.

Investment Strategy:
A possible strategy here is to be long junk bonds and short equities. If the argument against holding junk bonds is financial armageddon (default rates will be higher than is priced in), then a strategy of going long junk bonds and at the same time, shorting equities should be a profitable one. In the worst case scenario where equities bounce (nothing is wrong with the economy), you
are protected by a rally in junk bonds as well as spreads come in. But should the economy implode, your short will do well and at least you get your recovery rate in junk bonds. If nothing happens, you get you close to 15% plus while waiting for either scenario.

I do not short so if I am going to execute this strategy I will buy a put on an equity index and go long junk bonds.

You can buy individual issues like GM, ford or utilities like TXU or you can buy ETFs like HYG or JNK. There are many closed end funds that hold High yields bonds that are trading at steep discount to their NAV so you can get more margin of safety by buying them.

Personally I prefer to buy the ishares high yield ETF (HYG). I will avoid leverage with closed funds and I will be more diversified than owning one or two issues of bonds. Moreover, HYG's holdings are invested in issues in the health care and electricity sectors, non economic sensitive sectors; those two sectors represent just under 25%.

The pricing of high yield bonds offer tremendous value with small probability of permanent loss of capital. For investors to lose on investment in HYG, for example, the economy has to implode at unprecedented rate, beyond great depression levels.

November 29, 2008

Value Idea: BAM Preferred Shares

I have detailed my case for the Bookfiled Asset Management (BAM) preferred here. I will elaborate on some additional points on its investment merit.

I have picked issue, which has the following characteristics:

  • Floating rate issue, i.e., dividends change depending on the Canadian prime rate.
  • The issue is redeemable at BAM option at $25 per share, i.e., the issue has face value of $25.
  • Dividends are cumulative, i.e, if the BAM decides to skip a dividend payment then dividends would still owed to the investor.
BAM's preferreds offer me an excellent opportunity to earn great return that I could not simply pass up. I have bought BAM.PR.B at $7.9 per share to earn a dividend yield of 10.5% annually. There is room of capital appreciation as well. The face value of these preferreds are $25 per share; they are trading at almost 70% discount to where it was trading just a year ago. I do not think this price will be the absolute bottom but in the long run the odds are in my favour to earn
satisfactory returns.

Brookfield Asset Management (BAM) has four operating categories from which it generates cash flows:

  • Property: those are unique properties in supply constrained markets, mostly downtown properties in major urban centres, mostly through its ownership of Brookfield Properties (50%), another holding of mine, although it operates some properties on its own as well.
  • Power generation properties in demand stable markets like North east and west cost.
  • Infrastructure assets like transmission lines and timber fields.
  • Asset management for institutional entities. BAM uses these funds and co-invest with its clients in the above three categories. moreover it does manage security instruments as well.
BAM have great management talent, which its philosophy is to buy unique valuable assets at a fair price rather than average asset at a discounted price. See this presentation by their CEO to appreciate the value philosophy of this management team. Moreover, BAM has been creating value to its shareholders by spinning unique assets, like Brookfield Properties and Brookfield Infrastructure.

This is a bet not only on the assets earning power but on management to deliver value. I think betting on management was underrated in the investment discipline, where asset value and earning power was the focus.

Additional points of consideration:

  • Interest rate risk: these are floaters and their dividends payment correlate to prime interest rates, so the risk of more interest rate cuts will lower its payout. Retail investors mostly hold preferreds and their actions are mainly driven by fear, so these shares trade violently each day and sometimes their trading does not make much sense. At current prices investors are pricing them as if interest rates will never rise again. I betting that interest rates in few years will rise and will rise rapidly, in such case these preferreds will gain. However if they do not I am earning more than satisfactory returns.
  • You could buy fixed rate preferreds and you will do well but I would like to reduce interest rate risk from this issue and floaters are great way to do it.
  • Cash flow levels are solid: Currently BAM have about $3 billion of core liquidity and generate about $2 billion of cash annually. Moreover, FFO per share for the third quarter was US58¢, up from US51¢ in same quarter of the previous year. Excluding net gains and unpredictable items, BAM’s adjusted FFO available for common stockholders at US50¢ per share, up from US45¢ a year earlier. Adjusted FFO is funds from operations after the payment of all interest and expenses. It is not quite the equivalent of free cash flow, but a good indicator that BAM is a good generator of cash. BAM’s cash flows remain solid, while it’s financial position is strong an it is cash rich at a time when others face forced liquidations and cash is king.
  • BAM has maintained acceptable balance sheet ratios with just under 30% debt-to-total capital (book value) and cash flow-to-debt of 0.33. BAM’s coverage ratios also remained strong in 2007, with interest coverage on a remitted basis of 5.3 times and fixed charge coverage of 3.9 times.
  • Debt level: BAM Investment-grade financing strategy is to hold fixed rate, diversified and long-dated maturities. The strategy matches their assets and reduces any risk of funding miss match that could lead to asset fire sale or forced liquidation. Moreover significant chunk of BAM's debt is non recourse. This deb is associated with mortgages on their commercial properties. Why is this important? because no single property can take down the company if it ran into trouble.
  • In the event of balck swan bankruptcy, my capital hold a good probability to be protected. If we assume a 75% liquidation value of BAM long term assets there will be just enough funds to cover preferred holder and wipe out common equity holders. Off course preferred shares rank higher than common equity and should see full recovery of their book value; book value of all outstanding preferred is $870 million. And because we are buying those issues at deep discount we have almost 45% margin of safety.
BV As of Q3 2008
Recovery values
Liquid assets- values will hold
Long term tangible assets
Less all liabilities
Surplus available for preferreds and common equity

I am not only like their preferreds but I like their business model and management. I am looking at their common valuation to determine if an investment in their common equity is warranted.

November 26, 2008 / Columnists / Martin Wolf - Why fairly valued stock markets are an opportunity / Columnists / Martin Wolf - Why fairly valued stock markets are an opportunity:

Great article about the valuation of today's market. I have been using the modified PE described in the article as my guide in valuing the market and as the article details the valuation of this market has not been seen in a long time.

Since the end of last month, I have been buying more of the market indices, like Emerging Markets index (EEM) and Russell 2000 (IWM). I have also bought Brookfield Asset Management (BAM) preferred shares, which I made the case for here.

There are great bargains especially in fixed income markets. I can say that in the fixed income universe you can find compelling risk/ reward propositions than in the equity markets, the BAM preferreds are such an example. I will have a future post talking about these opportunities.

November 16, 2008

BofA out Amex in

I am rolling my capital allocated to Bank of America into American Express (AXP).

I have been mulling getting out of BofA position for awhile. The buyout of Merill Lynch have changed my outlook on the bank. Mainly due to the integration risk and the diverse cultures of investment banking and retail. This merger would have been difficult to complete in normal circumstances but with the stress of bad economy and credit crises this could be impossible to pull off.

Also the financial landscape has changed a lot since my investment in BofA. BofA, as I reasoned when I made my investment, held a competitive advantage over its peers by being the largest retail bank with coast to coats network of branches, which ensured that it held a relative competitive advantage in its economies of scale to its peers. Now with the rapid continuing consolidation in banks, that is no longer the case. Other banks like JP Morgan and Wells Fargo achieved that position by buying Wachovia and Washington Mutual. So that relative competitive advantage disappeared, which can lead to margin compression over the long term.

Buffet also sold out of BofA so I get my confirmation to my thought process.

I am not saying BofA will perform badly, but there are more risks associated with the business. BofA management is still good and have a lot of experience with merger integration and the opportunistic acquisitions they made in the last 6 months can secure their position in the global banking industry. However the return is more speculative than say with AXP or JPM.

My cost basis for BofA is $42 per share I sold it at $18 for a loss of 57%. That hurts. But I will not dwell on it, as I need to find the best risk/reward proposition for my capital and at the moment BofA does not fit that bill. American Express, on the other hand, will offer me a better return, I think, once market settle down. I bought AXP at $20 per share.

AXP has several competitive advantages that makes it a unique investment.

  • brand: BusinessWeek ranks it 15th out of 100 most valuable global brands.
  • network that akin to toll bridge earning fees on transactions from retailers and interest and fees from users
  • retailers have limited bargaining power in this industry. Credit card networks can increase fees with little of resistance from retailers.
  • what will be good for BofA will be good for AXP, while the opposite is not true. BofA will have specific risks associated in its operations that can overwhelm its earnings.
  • Buffet ownership gives a backstop for any permanent loss of capital in AXP, while with BofA government involvement present a risk for permanent loss of capital, think of AIG.
  • With the sale of BofA i generate some tax loss amounts that will be used to offset some of my earlier capital gains in the year, something I think I will not discuss for awhile.

Here is a good case for AXP as undervalued investment by Vitaliy N. Katsenelson.

I think by redeploying capital from BofA into AXP I will be better served. I will sell my investments when I believe that I could redeploy the capital in investments that offer more attractive risk-reward profile. I will always be willing to sell an existing holding at a profit or a loss, if I can find a better use for the funds.

November 7, 2008

NorthStar business model re-evaluation

Any lending operation currently are re-evaluating their going concern and the future of their business model. Any financing operation without a stable deposit base is at risk and have a bleak future. That's why the investment bank have disappeared from wall Street. But this change will affect many other operations depending on leverage,like leasing companies, mezzanie funds, commercial real estate reits..etc. One of my holdings NorthStar realty is one of those affected as it is a commercial financing company.

The entire sector of REITs specializing in financing commercial-property transactions are facing headwinds. Companies like NRF, Gramercy, CBRE Realty Finance Inc. and Arbor Realty Trust Inc., have seen their access to capital severely reduced by the credit crunch. They are also suffering from a dearth of property transactions and rising defaults.

The business model of traditional commercial-mortgage REITs -- which act like leveraged bond funds, making money only if the yields on their investments exceed the cost of their borrowings -- has been rendered obsolete by the credit crisis. Early this year, Gramercy bought a REIT that owns real estate to help diversify its business.

from the Wall Street Journal:

The reason: These companies have depended heavily on the ability to sell securities stuffed with the loans they originated, called collateralized debt obligations, or CDOs, in order to lock in financing for a longer period of time to match their mortgage portfolios with long-term maturities.

Today, with the CDO market all but shuttered, there is a lack of long-term debt financing that they can rely on to fund the acquisitions of assets.

"While I expect further loan impairments, the real focus will be on liquidity and any potential violation of their credit facility and bond covenants,"
NorthStar already has diversified away from the mortgage reit model into operating commercial real estate business before the credit crises. NRF has diversified into Net-lease operations through two joint ventures, Wakefield Capital, LLC, owning medical facilities and another venture, LandCap partners, with Goldman Sachs to buy distressed land rom home builders.

They have just reported their earnings and I have to say the report looked really good. Here are some highlights:
  • continue to buy back their own CDOs at 50% discount; mark-to-market works on both sides of the balance sheet.
  • The have no non performing loans (NPL).
  • Book value increased to $15 per share from $12 in Q2 2008
  • Management owns better than 10% of the company
    and is managing for the long term.
  • very good liquidity and cash position.
  • reaffirmed their dividends.
Despite an excellent report this quarter, management did indicate some
potential problems:
  • There are very uncertain loans on their watch list which very easily can become NPL; of especial significance is the WaMu tenant lease which brings over $5 million in revenue per year. JPM after taking over WaMu from the FDC has 90 days from acquisition to decide what to do with the leases.
  • NRF is accumulating cash and not doing much loan origination, which will impact future earning
  • also management said their earnings will be less if LIBOR continues to decrease which is what they expect, again hindering their net income and dividend.
I think at this point I will keep my investment in this business as the fundamentals and the reasoning that I bought NRF are still valid. NRF has a favorable chances of surviving this episode of the crises and emerging as a commercial real estate company. Yes the price have dropped significantly, and chances are it may drop further, from my cost basis but I think I will hold this one.

November 4, 2008

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test -

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test -

A great article about AIG reckless underwriting of credit default swaps. The article is a great illustration on the difference between risk and volatility. I have argued this difference in several posts and I still believe that a lot of investors, even professional, as illustrated by this article, confuse risk and volatility.

Several take away from the AIG case:

  1. Models do not articulate risk, they articulate volatility.
  2. Common sense and conservative policies go along way in protecting capital.
  3. Historical data should not be relied on for investment decisions entirely; it can always be manipulated to show whatever case you want them to show.
  4. Good and conservative management matter much more than assets and technology.

Value idea: Preferred Shares

The dislocation in the market has presented several opportunities not only in equities but more so in debt instruments. Here is one example the preferred shares of Brookfield Asset Management (BAM).

Brookfield Asset Management Inc. (Brookfield) is a global asset management company. The Company operate and manage assets in property, renewable power, infrastructure, specialty investment funds, and fixed income and real estate securities. The subsidiaries of the Company are Brookfield Homes Corporation, Brookfield Properties Corporation, BPO Properties Limited, Multiplex, Brookfield Power Inc., Great Lakes Hydro Income Fund, Brascan Brasil, S.A., Brascan Residential Properties, S.A. and Brookfield Investments Corporation.

Upside potential of the shares:
  • The preferreds trade at Junk level valuation. Pref issues M and N trade on a perpetual basis at 11-12% discount rate. However, BAM is an investment grade rated firm; its rating was recently affirmed by DBRS.
  • The preferred shares have a current yield of 9% for the two issues, at that yield you can double your money in about 10 years.
  • Strong management team that have strong acquisition and valuation discipline
  • Long term quality assets in place from power, infrastructure and property.

Downside risk for the preferred in particular:

  • Interest rate risk: typically preferred shares go up when interest rates go down. This relationship have been broken lately due to negative sentiment and investors liquidating out of fear. The relationship will return to normal levels in due time. However the prospect of central banks raising rates in hurry after the credit crises subsides can hurt the preferred.
  • Liquidity risk that can lead to withholding dividend payments.
  • Leverage risk / adequate debt service provisions.
  • Redemption risk as the company can redeem the issues at its option however the risk comes with a nice upside as it will be redeemed at par.
  • Conversion risk to common by the company. Here the company can convert the issues to common but with a premium to the trading price of the common shares.
  • Black swan: any event leading to company bankruptcy: book value of the company is $3.2 Billion ( total assets less intangibles less liabilities). If we assume a bankruptcy recovery rate between 55%-65%, reasonable rate as based junk bond historical recovery rates, we can see up to $2.5 billion to recover for equity and preferred shares. Off course preferred shares rank higher than common equity and should see full recovery of their book value; book value of all outstanding preferred is $870 million. And because we are buying those issues at deep discount we have almost 45% margin of safety.

Which issue to choose?
It depends on several things. you premium on liquidity as many issues have limited liquidity than others. Some issues have floating rate dividends while other have fixed rates. This requires more research on your part.

I am going to zero on issues B, M and N for selection.

November 2, 2008

Expert prediction: flipping a coin is better

Let me begin this post by two endearing quotes about economists:

An economist is expert who will know tomorrow why the things he predicted yesterday didn't happen today
Lawrence J. Peter

Economics is an extremely useful form of employment for economists
John Kenneth Galbraith

Media has reported on economists and investors who called the crises and profited from it. Some of those people are John Paulson the famed hedge fund manager who made multi billion dollar in 2007 betting against sub prime. Another is Prof. Roubini who "predicted" the crises and continue to give sound bites to the media.

I always enjoy reading about the newly minted expert of a crises or an episode of the economy. Before Paulson and Roubini there was Abby Joseph Cohen, the famed Goldman Sachs strategist, who called the S&P during its bull run in the 1990s and was hailed by media as the market genius. Internet companies had their prophets as well. There are a host of so called "experts" who came and gone. Those experts rode their once in a life time call on economic or market matters but disappeared into the sunset when they tried to do it again. I reckon that Roubini and Paulsn will face the same fate.

Lets look at these experts in another light. If there are 20,000 experts, why does only one guy have this figured out? What is special about them?

Walk into some big arena filled with 20,000 people each standing and holding a quarter. Ask them to flip it one time: heads you remain standing, tails you sit down. Repeat the trial 14 times among the people who remain standing only. A normal distribution of outcomes would say after fourteen trials you would reasonably expect one person to be standing up, actually 1.22 to be exact. Ladies and gentlemen, I give you Professor Nouriel Roubini, Andrew Lahde Capital, who saw his accomplishment for what it is and called it quits, andPaulson.

My point of the post is economists and the "expert" of the day had his/her lucky call, odds are stacked against his next call to be right. Do not chase expert and their performance as predictions are always harder when it is about the future!

November 1, 2008

Acman's value idea:Target Spin-off

One of Target (TGT) largest shareholders, Ackman, the hedge fund manager of Pershing Capital, have proposed a transaction to unlock value in TGT. You can view his presentation here. I have to say that I always enjoy Ackman's work; it is always detailed and a learning experience.

I have to say that the transaction does not make much sense to me. It is a lot of financial engineering that, most likely, will not create any value to shareholders.

The core of the transaction is to spin-off of the land that TGT's stores are build on, TGT keeps owning the buildings, into a REIT that will charge TGT rent and perform building maintenance and development of new stores. The REIT pays dividends to shareholder and because it is a REIT it does not pay any taxes. According to Ackman TGT will be $70 after the transaction and $83 in a year, somehow. What the transaction boils down to is : tax. That is it. The new structure eliminate some taxes, actually, redistribute it to you , the shareholder.

My problem with this is creating value by tax redistribution only is tax policies are outside management control. Tax policies can change therefore relying on a tax policy to create value can disappear very quickly. Management can create better sustainable value by using some of the levers it can actually control: revenue, expenses and cost of capital. The transaction is a lot of ado about nothing in my opinion.

A company value is the perpetual discounted present value of its free cash flow. Then, there are two way to create value for shareholders.
  1. increase free cash flows, and that can come from two things:
    1. increase revenues
    2. increase operational efficiencies or decrease operating expenses and capex.
  2. decrease the discount rate or the cost of capital, a company can accomplish this by:
    1. decreasing borrowing costs,
    2. optimize the company's capital structure.
None of Ackman financial wizardry do any of the above. TGT is an excellent retailer with good management but I do not think the transaction adds much to the pie.