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.
Source: www.arpllp.com.

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.

Valuation:
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.