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:

Symbol
Price$
Yield %Premium/ Discount to NAV%
PFN
5.13
23.09
-22.51
FRA
8.40
16.4
-10.45
PHD
6.11
22
-22.14
EVF
3.18
16
-11.67
BHL
9.11
14.82
+4.83
PPR
2.85
14.32
14.67
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:
Fund
Why I excluded it
PFN
  • 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%
FRA
  • 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
    portfolio.
  • 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.
EVF
  • The fund is leveraged by preferred shares and notes payable. The combined leverage is 45% of assets.
BHL
  • 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.
PPR
  • 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.

19 comments:

marklandecker said...
This comment has been removed by the author.
Anonymous said...

Sami,

Appreciate your work here. I have been doing similar analysis. I have a quick question as while we only have Sept 2008 stats for PHD , I calculate leverage as follows.

Original face of ARS: $234m.
Bought back thus far excluding redemption later this month: $30m
Current leverage: $204m ($234 less the $30m repurchased in November)

NAV as of Friday: $189m (24.4m s/o x $7.76 NAV per share)
Total Assets: $189 NAV + $204m leverage = $393m
Leverage as % of total assets = 204/393 or 52%

But I realize PHD would be exceeding regulatory allowed leverage if the above math is correct, and I see they are paying their dividend. What do you think I am missing here? Is it likely due to the fact the fund just recently went over 50% leverage but was not in excess of 50% at the time the most recent distribution was declared?

Lastly if you post an email address I can email you a spreadsheet template where I have been trying to model out IRR's for various ETFs assuming things worsen before improving.

Sami said...

your calculation is good. I was using their financials which will give lower leverage due to deterioration in assets prices.

do you have other funds in mind?
you can send me the spreadsheet to:

sami(dot)alhussieni(at)gmail(dot)com
Thanks

Boyan said...

Interesting analysis... Looking quickly through PHD's financials I see some wireless holdings, as well as Ford and Tribune bonds. Assuming that this list is up to date, the presence of Tribune answers one of the questions you posed earlier --- that they ride the bond through bankruptcy settlement, and don't dump it when the issuer goes under. However, I noticed that the average credit rating of the bonds they hold is "B", does that impact your assessment of default and recovery rates of the senior notes?

Sami said...

Boyan,

it will be interesting to see if they keep them.

But after I wrote the post I went looked at their historical filings to see if they hold chapter 11 notes. They do. they held Delphi paper before it went into chapter 11 and they still hold it. But I am still looking to see if they hold claims in bankruptcy not mere reorganization. I have noticed that they do have some claims on Northwest airlines, but it is such a small amount to draw any conclusion .

the rating does not impact the analysis. Actually most of the bank loans that these funds hold are non investment grade. the point is at this price and the seniority of the loans make a backstop to any permanent losses through the recovery of more than what I invested from a bankruptcy proceeding

j'adoube said...

Right now, these closed-ends are absurdly volatile. PPR is up about 30% in 3 days, going from a 20%+ discount to a premium.

When you buy the closed-ends, you introduce three risks you don't have in a nice unleveraged open-end:

1) Discount/premium fluctuations
2) Leverage
3) Leverage violation issues (potential high negative alpha from this last factor)

These three risks have nothing to do with exploiting the cheapness of bank loans. In fact, they're present in other CEFs in other asset classes.

So the purer play, one that does not dilute the cheap bank loan trade with these other factors, is the unleveraged open-end fund trade.

And about the only ones I've found are EIBLX/EVBLX and FFRHX. Both solid funds that don't seem to be encountering drag from redemptions.

I contend that, owing to the outrageous volatility in the CEFs, the open-ends will exhibit superior RISK-ADJUSTED returns. And they provide the staying power in a difficult climate.

But as far as the CEFs, congrats on the timing of your post!

Sami said...

j'adoube,
the timing is pure coincidence and I would not take any credit for it.

I agree with you on the risk inherit in CEF but open end funds will have the same risks sans the leverage. with open funds you will expose your self to redemption calls, which will lead to the same outcome: premature selling.

the open end fund have a mis-match funding risk, that is you hold some what illiquid and long term securities in bank loans and finance it with on demand funding from unit holders. that is why I think open ended funds are as risky, if not more risky.

for that reason CEF is better with the ones that have leverage in the form of preferred. this way the leverage can't make you sell prematurely. Also you get additional return from the snap of discount to NAV.

Ben said...

Sami,
I just discovered this blog and it looks like you do some great analysis. In researching senior bank loan funds I came across a recommendation for JFR. Is there a reason its excluded from your analysis? Thanks,
Ben

Sami said...

Bryan,

no reason I did not survey all funds. but I have taken quick look.here are my initial thoughts:
1. right now it trades at par. I want to have the fund that I invest in trade at a discount of 10% or more.
2. heavy exposure, some 25% of funds assets, to media and hotels not exactly good sectors to lend to. Hotel are overbuild and room occupation is going down fast. Media advertising is slowing and some newspapers are defaulting.
3. low average coupon compared to others CEFs
4. it is leveraged, although the form of leverage is preferred share better than loans but still there is leverage as this one can force fund manager to sell at importune time.
these are my initial thoughts as I went through the fund material.

Anonymous said...

Sami - thanks for the idea, does seem interesting indeed. I had a quick question regarding the preferred shares – from my read of the docs, it appears as if the preferred can force asset sales if the fund trips the net worth covenant. I am sure that I am missing something and wanted to get your thoughts.

p42 - p43 of the PHD annual report:

"The AMPS are redeemable at the option of the Trust, in whole or in
part, on any dividend payment date at $25,000 per share plus any accumulated or unpaid dividends, whether or not declared. The AMPS are also subject to mandatory redemption at $25,000 per share plus any accumulated or unpaid dividends, whether or not declared, if certain requirements relating to the composition of the assets and Pioneer Floating Rate Trust liabilities of the Trust as set forth in the Agreement and Declaration of Trust are not satisfied."

I also checked the prospectus to the preferreds and saw the following language on P68:

“Mandatory Redemption. The Fund is required to maintain (a) a discounted value of eligible portfolio securities equal to the Preferred Shares Basic Maintenance Amount and (b) asset coverage of at least 200% with respect to senior securities which are equity shares, including AMPS ("1940 Act Preferred Share Asset Coverage"). Eligible portfolio securities for purposes of the Preferred Shares Basic Maintenance Amount will be determined from time to time by the rating agencies then rating the AMPS. If the Fund fails to maintain such asset coverage amounts and does not timely cure such failure in accordance with the requirements of the rating agencies that rate the AMPS, the Fund must redeem all or a portion of the AMPS.”

Sami said...

Hi Anon,

you are not missing anything. yes if the fund NAV falls below the covenant it has to redeem the AMPS and it can do that be selling assets or suspending dividends. that is the risk of leveraged CEF. I have discussed it as a possible drawback compared to open end funds.

Anonymous said...

Sami,

What are your thoughts about investing in local currency emerging market debt fund? There are not too many. Can you please share your thoughts?

Sami said...

Anon,

Look at my post re Emerging debt here:http://myvalueidea.blogspot.com/search/label/Emerging%20Markets.

I liked them more in October and I though they were fantastic deals. Now they have run up so much that the value proposition is less appealing. If you buy now I doubt you will make any above average returns.

Anonymous said...

Sami,

Thx for your response. I did read your earlier blog about investing in emerging market. Unfortunately, I did not find any specific CEFs for local currency em debt bond fund. I agree with you about their run-up in the past 6 months. However, I want to be ready if the market does go down in the fall. In the meantime do you think floating bank rate loan fund are still decent investment vehicles? Especially, if the yields on the govt. bonds keep rising?
BTW- I am a new visitor to your blog and have already become a regular. Keep up the good work!!

Sami said...

Thanks for the nice words.

Also the loan market has run up. The impact of treasury rise is an added risk but on historical basis the rates are still low. I do not buy the inflation reasoning that much so i will consider the risk small for a huge run in rates. I could be wrong.

Anonymous said...

Sami,

What looks interesting to you right now? Is cash king? What's on your radar screen? I think stocks are in for a tough road and that is why I was evaluating fixed income like bank loans, emerging market (dollare based & local currency based) vehicles.

Sami said...

right now I am sitting on my cash. looking more on debt rather, tobacco companies debt in particular, than equity.

Also, sifting through and learning on the way about bankruptcies as some of these cases has to represent some value.

I want to put a speculative play by buying out of the money call options on long term treasuries. They have been selling off because all expecting inflation but I am not in that camp. The only thing preventing me is it does not fit in my process. Damn the discipline :)

Anonymous said...

Sami,
I agree with your idea of playing in the debt vs. equities. That is why I am interested in emerging market (local curency and dollar based) bond and bank loan funds. What's a simple way for an individual investor to invest the tobacco company's debt? Are you looking at senior loan, corporates or converts?

Sami said...

corporate either Altria or Lorilord.