December 29, 2008

Debt with Equities Like Returns

Debt seems to be a theme for me over this year. most of my purchases were in debt related instruments. I have invested in Commercial real estate debt, bank loans and the quasi debt preferred shares.

1. Purchase of bank loan Close-end-fund PHD at $6.75:

The Credit markets recovered over the few weeks particularly in the non government debt. Some of the funds that I was analyzing for investment in bank loans have moved up, some by 30%. The spread on bank loans have come down significantly from few days ago as displayed
in the chart.

There are a lot of improving signs in the credit environment:
  • LIBOR is came down and it should provide significant debt service relief
  • Mortgages are down to historic rates
  • Corporate yields are down indicating trust in corporate paper or at least some money is moving into that market.
  • even high yield rates have gone down.
  • all this is accomplished with treasuries at historic lows still, i.e. the spreads are still the same but yields have came down because people are buying and capital is flowing into the credit market rather than treasuries.

2. Commercial Real Estate Debt:
I have bought NorthStar Realty (NRF), maybe prematurely in hindsight but I still like it, to capitalize on the cheapness of commercial real estate debt.

From Bloomberg:
Top-rated commercial-mortgage bonds, which returned 32 percentage points less than Treasuries in October and November, have offered a record 12 percentage points more than government notes through Dec. 24, Barclays Capital index data show.

Debt markets are improving amid hopes that prices fell enough to account for potential defaults and as the U.S. government continues efforts to thaw credit and curb a yearlong recession. One of the AAA classes of a $7.6 billion 2007 Goldman Sachs Group Inc. commercial-mortgage-bond deal, considered a market benchmark, has jumped 24 percent, according to Ken Hackel, head of fixed-income strategy at RBS Greenwich Capital Markets.
I am considering to double down in the new year on the name; I am waiting for the possible dividend cut first. NRF will make it through this crises and will have high odds of making high returns:
  • The company has $326 million in cash while its market cap is about $250 million.
  • Its portfolio of loans are predominately prior to the 2005-2007 glut of weak underwriting and loose credit standards.
  • It has underwritten all of its loans so it has first hand knowledge of its economics.
  • Management owns 11% of the company so its interest is aligned with shareholders.
  • It has a large portfolio of health related commercial real estate which is doing strongly and values are going up.

3. Preferred Shares
I have accumulated preferred shares in Bombardier and Brookfield Asset Management to take advantage of price volatility versus the credit worthiness and strength of their balance sheets. I will add to both of these positions in the future.

I think debt have sold off more than equities and was offering equities like return with much better security in the event of default. Investors have raced to buy Treasuries for no return and it will not be long that they will seek better yields in the credit markets.

I have an equity purchase that I will make in the new year and I anticipate to be a big chunk of my portfolio. I have been studying the company for over six months and I have gotten a very comfortable feel of its competitive advantage and prospect.

Hope you have a happy new years!

December 20, 2008

Distress Investing

Please consider reading Third Avenue Funds shareholders letter about investing in the distressed assets and investing in this new era.

He details a case for investing in debt instruments of the financially distressed companies. Distressed investing is highly rewarding but you have to consider its fit for your own competence and abilities. Distress investing needs sophistication and expertise in areas of law, accounting and negotiation, or access to talented resources that can provide you with the help needed. Investors need to understand their abilities before buying these issues. In my opinion distressed security investing is best left for those who specialize in it. In such markets where information is scarce, those who are informed will take advantage of those who are not.

Please consider chapter 12 of Seth Klarman's Margin of Safety for a premier on the subject. You can read the whole book as it is a good summary of how an investing process should run.

December 14, 2008

Senior loans: how to invest?

LCDX Graph
I have posted about senior bank loans as an attractive area in the debt market right now. The tenant of the thesis is as follows:
  • defaults will increase beyond 10% however recoveries on first lien and senior loans will be better than junk and could come at 50-60% below the 75% historical average
  • at 70 cents on the dollar the IRR will around 22%
  • the principal is almost covered by the recovery of the defaulted issues while you can enjoy a wide spread yield over treasuries.

However what I struggled with is how to invest in this idea. Individual loans are about inaccessible to retail investors and you need a large number of issue to diversify. Open ended funds can struggle with redemption forcing them to sell at inopportune time. On the other hand closed-end-funds (CEF) do not have that issue; shareholders can sell on the open market. I have narrowed the the alternatives to the following CEFs:

Yield %Premium/ Discount to NAV%
As of Dec 11,2008

I have considered the following questions is my selection:

  1. What sectors make up the majority of the funds assets?
  2. What type of bank loans: senior vs second lien?
  3. What is the percentage of leverage employed? Is it debt vs preferred leverage?
  4. What is the discount to NAV? Is it bigger that historical averages?
  5. What is the manager quality: tenure, rating and his/ her commentary and communication to unit holders.

My preference is to buy PHD as a vehicle to invest in this theme, here is why:
  1. 18% of assets are in health care loans, which a bit safer and should outperform.
  2. The majority of their loans are senior; senior loans make up 88% of the funds assets. There are some second lien loans but does not make up a significant percentage of the fund.
  3. The fund trades at 22% discount to NAV compared to 11% historical average. The large discount is a result of the recent suspension of dividends due to preach of preferred shares covenants. However the dividends have been resumed.
  4. Its leverage is in the form of preferred shares which can not force the fund to
    liquidate like loans. The fund already started to pay it down. Preferred leverage is 38% of total assets and the fund began to redeem
    some of this leverage earlier this month. Total preferred outstanding is $234m and the fund redeemed $10m worth of these securities.

Off course there are many other funds that I reviewed but I did not like for a reason or another. Here are some of my notes and thought on those funds:
Why I excluded it
  • high degree of leverage employed by the fund. It had 57% leverage as of October 2008. However most of their leverage is in the form of preferred shares.
  • between corp bands and senior loan the fund has a big exposure to financial services: 10%
  • 73% bank loans that include subordinate loans the fund does not have to
    hold senior loans. there is a fair amount of second lien loans in their
  • The fund is conservatively leveraged at 26% but the leverage comes in the form of loans and notes payable very different than preferreds. Debt can be called forcing the fund to liquidate at a loss, while preferred shares, depending on the indenture, usually, redeemed at the fund option.
  • the fund is trading at its average historical discount of 10% to NAV.
  • The fund is leveraged by preferred shares and notes payable. The combined leverage is 45% of assets.
  • The fund trades at a premium to NAV. The fund also newer so it might explain why it is trading ant a premium. the leverage deployed maybe lower than other funds but it is not that low. It may have to do with fund manager buying shares in the fund.
  • insiders are buying; they bough $474,000 during the last year
    in the fund. Actually, insiders hold close to .5% of the fund outstanding units.
  • the fund total leverage is 40% of total assets. leverage
    in this fund comes in two types: loans and preferreds. I am worried about the loans
    part. The fund is substituting preferred financing with notes payable.
    probably to satisfy Citi as it needs its money back from the frozen ARS.
    The form of leverage is going from OK to worse.
  • Citi group owns 21% o the preferreds and an entity like CIti can push the fund into decision that are not in the best interest of unit holders. I am speculating that the move to issue the notes payable to redeem the preferreds was as a result of Citi's demand.
What do readers think? I have some discussion with some readers interested in the theme and I value their input.

December 12, 2008 JPM Buying CLOs Worldwide

- JPMorgan Chase & Co., the largest U.S. bank, is seeking to buy as much as $780 million of AAA rated portions of collateralized loan obligations, according to a list of securities the company circulated to traders and investors.

The bank is asking for offers tomorrow from holders of the debt backed by high-yield, high-risk corporate loans, said five traders who declined to be identified because the request isn’t public.

I have talked about how the market for bank loans is an opportunity right now. Buying these a portfolio of these loans and holding them to maturity or default is almost a no brainer investment.

JPM and others are beginning to raise demand for these loans. However other than buying CLOs, the retail investor is limited to closed-end-funds, which have their own associated risk, in the form of leverage, to capitalize on the idea. In addition, CLOs have over funding provision that can enhance security for the most senior tranches.

December 7, 2008

Value Idea: Bombardier Preferred

I have bought another preferred issue. The issue is BBD.PR.D trading on the TSX. It pays $1.31 or 13% yield. The issue pays fixed dividend until August 2012 then it exchanged for a floater paying dividends equal to the prime rate. I have managed to buy a small position on Friday@ $10.26 on the TSX, waiting to add more.

Business Overview
The company manufactures jets and train systems; its revenues almost split evenly between the two divisions.

The majority of its sales comes from Europe, while sales in Emerging markets are growing at a healthy clip. BBD has been announcing major contract wins over the last 6 months. The company will be further aided by the rapid decline in the Canadian dollar as it will lower the cost of BBD's goods to foreigners. The Canadian dollar is expected to remain subdued if a weak recovery and the pressure on commodities that would likely accompany it follows the global economic slowdown. After all, the loonie is 96% correlated to commodities, according to UBS. The company has a huge backlog of orders and potential for margin improvements; its backlog of $52 Billion.

Credit Assessment
The debt has been reduced by strong cash flow from operations. BBD's total debt in 2005 was $5.7 billion in the latest quarter it was $3.8. The company financial position continues to improve and coverage and leverage ratios are improving. In addition, the improving business fundamentals and growing revenues will allow for more improvements.

BBD's cash flow are strong and improving:
  • The company has cash position of $3.3 US. almost equal to its long term debt.
  • Free Cash flow to total debt have risen from 17% in 2005 to 42%.
  • Cash From Operation (CFO) has grown from $768 million in 2005 to $2 Billion in 2008.
While its Balance Sheet continues to de-leverage:

  • From table above liquidation value of assets is almost twice of BBD's total borrowings.
  • If I apply the same calculation from table above to historical figures we can good improvement. The liquidation value has undergone a drastic improvement in the quality of the collateral that secures BBD's debt and preferreds over time. (see chart)
  • Coverage ratios are also been improving

The BBD.PR.D issue price action does not make any sense over the last few months. The preferred should have some downside protection compared to the common. The preferreds with better security and dividends have mirrored the price performance of the common. The preferred is down 35% just the same as the common over the last 12 months.

Moreover the preferred dividend yield of 13% is higher than the common expected earning yields of 8.6% (P/E inverted).

What can go wrong?
  • BBD out of business: In this event I think there are good odds that the liquidation value of its assets can cover liabilities and unfunded pension benefits and spill over to common equity.
  • interest rates: higher rates in the future can decrease the preferred value, but it will be a floater in 2012 offsetting such risk. In the meantime I enjoy fixed rate.
  • liquidity of the issue: The issue has low volume so entering and exiting has to be done slowly. I still have not accumulated my full position but I am waiting opportunistically for good entry prices like the one I got today.
  • Sales backlog can be delayed by customers. However the train division will keep churning revenue and grow at high rates as government around the world spend on infrastructure to stimulate their economies; the company will be a beneficiary.
  • Pension plan unfunded liabilities. The company has a relatively large unfunded pension liabilities.
Given these risks, I think at this price and coverage ratios detailed above I have enough margin of safety not to risk any permanent loss of capital.

Over the past few posts I have been saying that fixed income is a huge opportunity these days. I can invest and compound my money at 12-18% in issues with better security than common stock. Some of these issues have a margin of safety that ensures there is no permanent loss of capital. I expect to make more investment like these. And to those who invest in treasuries earning less than 2% because it is risk-free, guess again!

December 5, 2008

Value Idea: Senior Debt

“There are no bad bonds, only bad prices,” the saying goes. And at these yields fixed income is a better opportunity than equities.

Although I was on the right track in my previous two posts, see here and here, about debt being a good opportunity, junk bond is not the right class at this time. I need better margin of safety either in promised yield or better recovery rate, which I can achieve by buying more senior debt in the capital structure. This can be accomplished by investing in senior bank loans.

Senior bank loans are
...close relative of its better known cousin - the high yield bond market. Both are bi-products of the busy private equity calendar of recent years. There are several types of loans in the market today. In the following I will focus on only the highest quality loans - the so-called senior secured loans (also known as first lien loans) which are essentially fully collateralized bank loans provided to companies which have restructured their balance sheets - often in connection with a leveraged buyout. The loans run for 4-5 years, sometimes longer, and are usually priced to yield Libor + 50-300 bps. They are issued at par, they mature at par (barring a default situation), and the typical loan-to-value is less than 50%, so the loans are usually very well protected. In a default situation, equity, high yield bonds, mezzanine debt and second lien debt all stand in front of senior secured loans when the creditors knock on the door.
What is your credit risk with these loans? The bank debt is, by and large, "senior," in the sense that in a crisis it would be paid off before junk bonds from the same issuer. Unlike junk Bonds they have better collateral and recovery rate making my thesis for investing in high yield debt a better one. Unlike junk, which can see recovery rate of 40%, senior loans historically achieved 74% recovery rate (Source: Credit Suisse). The seniority of the bank debt makes up for some of the weakness in the borrowers' balance sheets. The long-term default rate on these loans is in the 2.5% range but was higher during the dark days, not so dark compared to today, of 2001 and 2002 (Source: Eaton Vance, asset management firm Annual report). However we are coming out of a credit bubble and historical average will be blown out of the water.

At the beginning of the month, senior secured loans traded around 80 cents to the dollar. Four weeks later the average price had dropped to 50-60 cents to the dollar.

The worst default rate for senior secured loans on record is 8% and the average historical recovery rate in bankruptcy situations is 74%. If you assume a 35% annual default rate and a 50% recovery rate, at current prices, the IRR to maturity is 22%.

How to invest in these Loans?
Loan participation closed end funds (like EVF or BHL and many others) -- which buy bank loans to the companies, as opposed to bonds issued by them -- are less risky than high-yield bond
funds in two key respects: seniority, as explained above and loans have floating rates. When interest rates rise, bonds lose value because their fixed interest rates become below-market. But loans hold their value because their interest rates follow the market higher, allowing loan participation funds to raise their dividends. Of course, when interest rates are declining, the interest rates on the loans go down, leading loan participation funds to cut their dividends.

There are risks inherit in owning the funds that own these loans. The same aspect of making these loans attractive, high recoveries in the event of default, typically is not being taken advantage by fund managers. I think most funds would sell tanking loans rather than ride them through a likely default/lengthy bankruptcy process.

Another issue is the leverage employed by these funds. Typically Closed end funds issue leverage from 25% to 50% of assets under management to juice returns. If assets value fall below 200% coverage, then dividends and distribution will be halted until asset coverage is restored.

So selection of which fund to invest in is paramount. Actually you can argue that to take advantage of this opportunity closed end funds is not the proper tool. I would consider it if I was given a good discount to NAV as a margin of safety.

I have the following issues to choose from: PHD, BHL, EVF. I have presented the case for this investment, the only question now is how to monetize this idea, which will a topic for another post.

December 3, 2008

Value Idea: Junk Bonds- Again

I want to discuss the Junk Bond idea again, as I am trying hard to kill this investment idea. I will start first with some commentary by Bill Miller from his recent communication with his investors regarding credit spreads:
One of the most important bullish signs has been little remarked upon. The monetary base, which consists of cash in circulation or in banks, had been decelerating during the entire [crises] time the Fed had supposedly been injecting liquidity into the system since last August. Thus, the amount of what economist Milton Friedman called high-powered money to stimulate the economy was decelerating, and so was the economy as the crisis continued. Now, though, the base is exploding as the Fed has finally turned up the liquidity pump. Since just after the GSE [Fannie Mae and Freddie Mac] seizure, the Fed began expanding the monetary base, so far by over $300 billion, an unprecedented increase. It takes a while for all that liquidity to find its way into the system, but find it, it should, and the transmission mechanism is typically through capital markets first. As it does so, the odds are very good credit spreads will begin to decline sharply and equity prices rise.
Right or wrong in his view, I always view macro economic forecasting as a roll of dice at best. I try hard to never merit any investment idea based on economic forecasts; the idea has to stand on its own merit. But I though it was a good mention.

Unlike equities, fixed income investing holds finite number of risks. These risks predominately are:
  • Liquidity Risk (ability to find bids on your bonds): If I hold individual names this would be a big one.
  • Interest Rate Risk: With fixed income, higher rates usually kills returns for bonds. However, junk bonds typically behave like stocks coming out of recessions.
  • Refinancing Risk: Ability for businesses to refinance their borrowings. This one will be acute since there is almost no credit circulating for good companies let alone junk status ones. And in an era of vanishing leverage junk companies will get no financing to roll their debt so defaults will be higher than previous crises.
  • Credit Risk: Generally this is a big one. And it is more paramount in this period than historically. We are coming out one of the largest credit bubbles in history, so undoubtedly writing standards for junk bonds in recent years have deteriorated from past years. That means that any historical averages for default and recovery rates will be almost irrelevant. Historical recovery rates averaged around 40%, I think that rate should not be remotely expected in this crises. Furthermore, the highest default rates on record were 15% recorded during the great depression era. Another point to consider is that the default rate is a blended rate across all issues from BBB rated to CCC and non rated issues. So with Junk bonds you have to assume higher rates. I will assume it will be 17.5-20%. The most recent years high default rates were recorded in 1990-91 as they topped the 10.14% and 10.27% respectively.

However the Case for Junk Bonds is as follows:
History tells us that U.S. Treasury securities generally outperformed spread sectors when financial markets were descending into crisis and investors were seeking a flight to safety. But history also tells us that these periods of out-performance were generally short-lived and difficult to time. And as markets emerge from these periods, and valuations begin to normalize, the yield differential of spread product over U.S. Treasuries could offer compelling value.

A look at the graph, (Source), we can see a clear relationship between Junk-Treasury spread and future incremental returns over treasuries. In all years where spread moved over the average spread of junk-treasuries, investors were rewarded with higher returns in junk compared to treasuries. For example, when the spread reached 10.5% in 1990, the forward year junk return was 26% over treasuries.

As the crisis atmosphere recedes and the economy improves, logic says that it will happen sooner or later, default risks are likely to recede. In this environment, spreads tend to normalize, which can lead to better relative performance from high yield bonds.

The question is, are the wide spreads pricing enough compensation in the form of higher yields to assume this risk of high defaults and low recoveries?

Breakeven Yield Analysis
I use simple breakeven analysis, demonstrated by Altman and J. Bencivenga (1995), to show the breakeven yield (BEY) that must be promised in order to compensate for expected default rates and recovery rates.
The end result is a comparison between actual yields at a point in time and the breakeven yield. This shows the yield premium (if any), at any point in time (i.e., the amount to compensate investors for risks, other than expected default risk, involved, e.g., liquidity, unexpected losses, flights to quality, etc).

The results are as follows:

Recovery rates
Default 20.00% 30.00% 40.00%
10.00% 12.42% 11.31% 10.20%
15.00% 18.11% 16.35% 14.58%
17.50% 21.22% 19.10% 16.97%
20.00% 24.52% 22.02% 19.52%

If we assume Armageddon with default rates of 17.5% and 20% recovery rates, I need to be promised a yield to maturity of 21% to breakeven with treasuries. Current yields to maturity of Junk bonds (JNK) is 21%, which is the breakeven point for my base case scenario. Anything better, junk bonds will deliver handsomely, and if these assumptions are too optimistic then it is not worthwhile investment. It seems that the promised yield for junk is at the edge, leaving no margin of safety for errors in my assumption and calculations.

IRR Cash Flow Analysis
The problem with BEY analysis is that it does not take account for holding periods and cash flows. So I will conduct an IRR cash flow analysis, it is the same that I made in my earlier post. Again the assumption, and they are unrealistically pessimistic:
  1. 5 year holding period
  2. 17% default rate throughout the holding period of 5 years, never will happen. You might get two years of high defaults.
  3. 20% recovery rate throughout the holding period.
  4. I assume I am buying Junk at 60 cents to the dollar.
  5. Average coupon rate of either JNK or HYG is 8.7%
  6. defaulted bonds are assumed non workable and will be removed from books, another unrealistic scenario, some of the defaulted bonds will be put to special service firms that will rework payments.
The results are as follows (all figures are with $1):
Year: 1 2 3 4 5
Par value $ 1.00 $ 0.83 $ 0.69 $ 0.57 $ 0.47
Coupon pmts $ 0.07 $ 0.06 $ 0.05 $ 0.04 $ 0.03
Defaults $ 0.17 $ 0.14 $ 0.12 $ 0.10 $ 0.08
Recovery $ 0.03 $ 0.03 $ 0.02 $ 0.02 $ 0.02
Net cash Flow $ 0.11 $ 0.09 $ 0.07 $ 0.06 $ 0.52 (return of principal:$.47)

My IRR is 9.57%, that return can be achieved by investing in more secured debt instruments.

I have backed away from my earlier conclusion in my previous post and I am less enthusiastic about junk bonds. The investment appeal rests with the assumption of defaults and recoveries. If you think that defaults and recoveries are going to be better than priced by the market then you have a good investment. If not then High Yield debt is appropriately priced by the market.

My problem with the junk bonds is that I am not getting a bargain. There is no margin of safety for potential errors in my analysis. To do this deal I need better promised yield from junk or better debt seniority, which will entail better recoveries and margin of safety.

December 2, 2008

Pimco Will Postpone Some Dividends -

Pimco Will Postpone Some Dividends -

Several closed end funds have suspended distribution to shareholders. The operational risks from closed end funds have surfaced due to the severe decline in assets and credit crises. I have noted to this when I have talked about investing high yield closed end funds. The problem is

... closed-end funds must maintain asset coverage of at least 200% with respect to senior securities, such as auction-rate preferred securities. That means for each $1 of preferred stock issued, a fund must have at least $2 in assets. A fund is prohibited from declaring or paying a dividend that would put it below the 200% asset-coverage ratio.

As a result of the market's declines, the Pimco funds' asset-coverage ratios have fallen below the required 200% level, the firm said.

However, most of these dividends are postponed and will resume once asset prices correct.