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.


Anonymous said...

Have you considered looking into buying Sears Bonds?

Sami said...

that's a great idea. sears bonds are good investment and better than equities at this time.

I know that the liquidation value of sears will cover its liabilities and then some. and at these yields to maturity it is a great bargain.

I will look into it more. Thanks for the idea. if you have any research or any work done on it can you share?

Randeg said...

Thank you for educating me on this issue. I am glad to have come to this article of yours as I didn’t know how to invest on debts and such. I have all kinds of stocks and mutual funds (I’m losing money on these now of course) but never on what you explained. I will wait for more of your posts.

Evelyn Guzman (If you want to visit, just click but if it doesn’t work, copy and paste it onto your browser.)

Sami said...

my pleasure. senior debt if held for at least 5 years will be money maker. just do not look at the prices each day.

j'adoube said...


Enjoying your site. I think that this is one of your stronger ideas, since the asset class is now priced for a depression-plus scenario, while equities are merely priced for recession.

On two different occasions in the past few weeks (at the Value Investing Congress, and then in Barron's), none other than Carl Icahn banged the table about the historic opportunity in senior bank loans.

However, the ideal vehicle for exploiting the mispricing in this asset class doesn't exist: An unleveraged closed-end fund.

Here are the problems with the alternatives:

1) Individual loans -- too much specific risk; illiquidity

2) Open-end funds -- redemption effect, forcing managers to sell at worst possible time

3) Leveraged closed-ends (including the ones you mentioned) -- leverage magnifying losses, perhaps blowing you out before the turn.

Problem is, all closed-end loan participation funds employ leverage. That's why some are down 75% or more over the past 12-18 months, with much of that pain occurring in the past two months.

On the other hand, the closed-ends allow you to buy these already cheap loans at further discounts of up to 20%.

So if the average bank loan in a closed-end's portfolio is trading at, say 65 cents on the dollar, then buying the fund at a 20% discount means that you're effectively buying the portfolio of loans at about 52 cents on the dollar. With a conservative recovery estimate of 50 cents or so in the event of default, you're squeezing a lot of the default risk out of the trade.

However, there remains volatility risk, or market risk. And your point is well-taken that these funds generally will not hold the loans through bankruptcy or even a workout. The folks at ING Prime Rate (PPR) told me that of 400 issues in their portfolio, they had only one in default, but that makes me think that may be because they sold other troubled loans before they reached the default stage, so as to present a clean record.

Anyway, I look forward to hearing your specific recommendations in your next post, as the opportunity is substantial and timely.

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Sami said...

Thanks. I agree closed end funds do pose their own risks to monetize the idea.

I think in order to take advantage you have to find a fund that is trading at a larger than normal discount to NAV. somewhere in 20% is good so you can leverage both the high yield on the loans and the revision to mean in the discount.

There are CLO, Collateralized Loan Obligations, which similar to CDOs but with bank loans, however they are not for retail investors.

Anonymous said...

I think the issue here, as identified is leverage and the fact that very few of the cef's are devoted exclusively to senior loans. Most have discretion to hold HY as well, and an analysis of holdings shows that is indeed the case.

Moreover a good many of the funds hold second lien loans which are still classified as senior loans despite the fact they are nothing more than HY with lipstick on (at least in my humble eyes). I agree this is an excellent space to spend time on, but I am still trying to find the optimal vehicle by which to invest.

The higher quality/low leverage ETFs don't trade at much of a discount (if any) in the space, while the lower quality ones are more levered and hold more HY. An obvious tradeoff between price and quality, and for me the correct choice is far from clear (tempted to go with higher quality at higher price however).

Lastly I am a little fuzzy on the Auction Rate Securities that most of these funds have used as leverage...from what I have read the market for most of these securities has failed and the funds are paying the maximum prescribed rate of interest. Longer term I just don't know if leverage using these instruments in sustainable (remember CEF can only use 33% straight leverage, vs 50% using ARS preferreds).

Sami said...


I agree 100% with what you said. The idea can be a loser because there is no instrument to capture it at least for the retail investor.

I still do not know how to invest and researching it. You know a good idea is for retail investors to pool their money and buy couple CLOs which are pure bank loans that can be held to maturity and though defaults.

I would go with higher quality but I would not pay a premium. EVF trades at 4% discount and actually holds some claims on defaulted debt. I sent some question so I will see what they answer on their policy about defaults.

The Auction Preferred are being redeemed by CEFs because they are frozen at the moment and no one buys them from their holder so funds have to redeem and deleverage. if the securites do not get resolve they could froze distribution to unit holders as there are coverage ratio by the indenture of these securities. Actually this a good thing. PHD have began redeeming some that's why they suspended dividends but they resumed it again and it trades at 20% discount but they hold some HY and second lien as you noted on your comment.

EVF vs PHD are the two I am looking at. Do you have any others to consider?

The other alternative is to go with open end fund? Any thoughts?

j'adoube said...

PPR is 98.5% first lien. Dan Norman is one of the longest-standing managers of bank loans.

But it's about 45%+ leveraged. Limit is 50%.

Eaton Vance has a lot of experience in bank loans. They run three open-end funds -- one that's mildly leveraged (25%), one that's unleveraged, and one that's unleveraged but includes about 15% high-yield. EV claims that redemptions have not been a problem.

My bet for staying power is the pure, unleveraged version, EVBLX (Class A)/ EIBLX (Class I). Yield is in the 8% range and average price, they say, is about 70. Sounds like it's overwhemingly first-lien.

Maybe, Sami, you can do some more research?

Anonymous said...

My concern with PPR is simply the leverage. As value investors we are ingrained to ignore mark to market moves, but in the case of a levered fund there is a consequence in that leverage must be unwound as values trade down. This reduction in value then forces a fund to delever (due to regulatory caps on leverage as you have noted).

To quote a Citi report "Obviously when a fund sells securities at a loss, it realizes that loss and it is not "recoverable," especially when proceeds from the sale are
used to repay debt. The capital is gone and, to some extent, so is the fuller opportunity to participate in any market rebound."

I am not overly fussed with distributions being cut and clawed back on a temporary basis to reduce leverage (the market seems to be already pricing this in on most loan CEFs). I just worry a bit about a continued selloff that forces a leveraged fund to unwind holdings at the most unfortunate time, thereby destroying equity in the process.

The IRR calculation concerning recovery and default rates has a kink in the thesis in that if a viscous selloff forces delevering, even if only for a month, then a fund may not be given the opportunity to ultimately realize a recovery on the existing value of the fund's current holdings.

I do agree with one of the posters that PPR strikes me as one of better managers when reviewing the commentary from historical quarterlies and literature. That said I don't have a good feel if the managers of PPR and EVF just sell a bond when it defaults or hold it through the workout and recovery.

Lastly I have read the Pioneer stuff. I just didn't get any warm fuzzies whatsoever from the literature. Regarding EVF, they hold a good number of second lien loans (about 50...not sure what % of NAV that implies), but their mere presence leaves me feeling uncomfortable. As a date point the ING Prime Trust guys wrote one quarter how they were explicitly avoiding lower quality 2nd liens.

I hope the above makes sense. All stuff I am mulling over. Just my throwaway thoughts.

Sami said...

I am doing research to see which fund to go with. But honestly every one has some negatives attached to it. the biggest one against all funds, closed or open, is that they get rid of their holdings once it defaults. They explained to me that their objective is income first and secondary objective is preservation of capital so dumping defaulting securities is a routine issue.

j'adoube said...


I just got a lead on Western Asset High Income Opportunity (HIO).

Appears to be unlevered, and its latest report shows it to be VERY heavily weighted in bank loans, maybe 80% to 90%.

Problem is that info from fund management is -- well, it's a brick wall. Stupid.

Another problem: HIO's NAV has barely outperformed PPR on the way down, despite the lack of leverage. Doesn't say a lot about manager loan selection.

On the plus side -- a solid if not spectacular discount.

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