Monday, March 15, 2010

Getting Toppy In Leveraged Loans

One of the greatest investing opportunities that emerged during the height of the credit meltdown in Q4 2008 was the implosion of the leverage loan market. While individual investors can’t access individual loans (since they usually trade in million dollar increments), several closed end funds issued by the big bond managers exist that exclusively comprise these floating rate bank loans.

One that caught my eye in late 2008 was the Blackrock Floating Rate Income Strategies Fund (FRA). While I have traditionally shied away from investing in open or closed end mutual funds, a few things really made closed end funds extremely attractive during the late 2008 timeframe. Firstly, bank loans were trading at 60 cents on the dollar. While individual security selection may have yielded better results, as an individual investor I didn’t have the capital to buy into this market. Buying a basket of high quality bank loans at 60 cents on the dollar seemed good enough.

Secondly, and more importantly in my opinion, an exodus from risky assets, drove the valuations on closed end funds to double digit discounts to net asset value (NAV). In fact, in November 2008, when I began to build a position in FRA, the fund was trading at a remarkable 20% discount to its NAV. Assuming the average security in the portfolio was trading at 60 cents on the dollar, I was able to purchase a basket of secured bank loans at 48 cents on the dollar!

While the credit meltdown left much to be concerned about, bank loan recoveries in bankruptcy have averaged in excess of 80 cents. As such, I felt my margin of safety was sufficiently wide, even under the most dreadful of circumstances. Add in a current dividend yield of 18% paying monthly distributions and I considered FRA a once in a lifetime opportunity.

So what happened? From a purchase price of approximately $8.50, FRA last traded at $16.35 for a 105% gain. Throw in $1.52 of cumulative dividends received since December 2008 for an additional 18% of income, and the total return equates to 123%.

While the appreciation in a reasonably safe security has been remarkable, all good things must come to an end. From a nadir of 60 cents on the dollar, the average bank loan now trades in excess of 90% of its face value. Even more concerning, FRA’s 20% discount to NAV has now turned into a 14% premium. As such, by buying FRA one is buying a portfolio of bank loans in excess of par. While a rebound in LIBOR could validate this premium (since bank loans typically pay interest that is indexed to 3 month LIBOR), I am always concerned when closed end funds trade at a premium to par. This is particularly the case with FRA given the spike relative to its NAV has only occurred within the last few weeks (see chart below).

As suggested in prior posts, the easy money in credit has unquestionably been made. While I will concede that I may be early, I strongly believe that the credit markets have crossed over from being incredibly undervalued in Q4 2008 to reasonably valued in Q2 & Q3 of 2009 to firmly overvalued as we exit Q1 2010. New issue deals oversubscribed by 5-6 times, closed end bond funds trading at double digit premiums to NAV, tens of billion of dollars of monthly inflows into credit funds (i.e. performance chasing), compression of spreads to well below pre-Lehman levels, and growing concerns about inflation, have all heightened my cautious view on the credit markets. Perhaps we get another 150-200 points of spread compression (implying 12-15% of upside on the average high yield bond), but too many uncertainties exist for investors to hold out for this last bit of upside.  

Wednesday, March 10, 2010

New Issue Market is White Hot

New issuance for the corporate bond market remains white hot, with several deals getting priced over the last few days. As I follow the building products space, I thought it instructive to highlight some of the deals that have been completed in my coverage universe. Notably, two leading suppliers, Masco Corp (owner of Behr paints, Kraftmaid cabinets, Delta & Peerless faucets, Milgard windows and several other leading brands) and Building Materials Corp of America (#1 roofing manufacturer in the US) tapped the bonds markets this week.

As evidence of the exuberance greeting the new issue market, I am told that both deals were approximately six times oversubscribed, with many investors coming away empty ended. Both bonds priced with a mid 7’s coupon and immediately priced up a point or so in the secondary market (further evidence of an ebullient market). As a point of comparison, Masco’s investment grade bonds traded in the high 70s in December 2008 providing investors a compelling 14% yield (nearly double the level currently implied by its new issue). Even more compelling, BMCA’s junior term loan (the piece of paper just refinanced at par as per the new bond deal) traded at 45 cents on the dollar at the depths of the market in December providing a remarkable 25.5% yield. This is even more striking considering that roofing had record years in 2008 and 2009 as asphalt prices collapsed (key input for roofing) and price increases implemented in 2008 were maintained.

While I am hesitant to call the top of the credit markets (particularly, since it could go on for some time), it is very evident that massive inflows into bond funds are compressing yields to unsatisfactory levels (or at least according to my discriminating standards). Investors have tired of earning zero percent yields in their money market & savings accounts and are moving billions of dollars per week into bond funds. This demand is overwhelming the supply of new paper and driving yields back to 2007 levels.

With quality deals like Masco & BMCA oversubscribed by 6x, it is very clear that we could be in the beginning innings of a renewed credit bubble. However, the new issue market is rapidly gaining steam and will eventually break the back of this technically driven rebound in credit. Sometimes I feel like the guy who was talking about a tech bubble in 1996 or a housing bubble in 2003, but I have little doubt that the credit markets have climbed to unsustainable levels. The only point I can make with relative certainty is that the longer this credit mania endures the more painful the reckoning will be when rationality finally creeps back into the market. Until that point, I would be more inclined to be a buyer of equities vs. debt since companies will be much bigger beneficiaries of cheap credit than their mindless lenders.

Friday, March 5, 2010

Analysis of InteractiveCorp Spinoffs

Spinoffs represent one of the greatest opportunities for diligent investors, particularly when the spinoff occurs prior to a meltdown in the equity markets. No better example illustrates this point than looking at the four entities spun off from InterActiveCorp (Ticker: IACI) on August 8, 2008. While each of the four companies: Ticketmaster (now part of Live Nation), Interval Leisure Group, Home Shopping Network, and Lending Tree declined between 75% and 87% from their initial spin-off price, all have been at least four baggers off their respective lows. Home Shopping Network has been the real star, appreciating by a staggering 1800% off its $1.44 low hit on December 8th, 2008.

Thursday, March 4, 2010

Return of Staple Financing for LBO Deals

It is quite shocking to me that less than one year after the complete demise of the credit markets, investment banks are reportedly offering aggressive "staple" financing deals to faciliate a new round of LBOs.  As reported by the Wall Street Journal ("Equity Firms Cheer the Return of Staple Financing; Critics Don't"), Interactive Data Corp, Michael Foods, Hillman Group, and Bresnan Communications have all received staple financing packages in the 5.5x-6.0x debt/EBITDA range.  While all four are quality companies that should attract ample interest from prospective investors, the indicative leverage levels harkens back to the 2006/2007 timeframe when purchase multiples were driven to unsustainable valuations due to leverage provided by the selling investment banks.   Admittedly, 6x is less than the 7.5-8x that existed at the absolute peak of the LBO boom, but still represents a level well north of historical averages (~4.5-5x).

As I have commented in past posts, I firmly believe that the credit markets are far more overvalued than the equity markets.  The compression we saw in spreads last year was due to robust inflows into credit and a lack of new incremental supply (i.e. most of the new issuance volume was due to refinancing).  With several large LBOs announced over the last few weeks, including the four mentioned above, the supply part of the equation may finally be tested as we progress through 2010.  Should inflows begin to moderate, the technicals of this new supply could force a widening in spreads, particularly if the Fed begins to tighten (though probably unlikely for the remainder of 2010).