Toys R Us redux (ii)

memory lane…

I took an international banking course in business school, way back when.  A case study of a project loan made by an international bank consortium to New Zealand made a profound impression on me as I was beginning to understand how banks work.

The loan was to enable the government to develop an offshore oilfield.  Borrowings were secured by the assets of the project; repayment was required to come solely from project revenues.  The key aspect of the loan, however, was that the loan principal came due at the end of year five but the first revenue from the project was expected to come only in year six.  

In other words, it was obvious to anyone who read the loan documents in even a cursory fashion that the original loan could never be repaid.  Not to worry, however.  This was the beauty of the transaction.  It guaranteed that a lucrative (for the main underwriters) refinancing/restructuring had to take place in year three or four.  The borrower may–or may not–have understood.  But these were the best terms it could get.

Loans like this ultimately led to the 1970s emerging markets debt crisis.

…and Toys R Us (TOYS)

…which brings me back to TOYS.  According to the Wall Street Journal, TOYS is trying to refinance $1.6 billion in junk bonds that come due through between now and 2018.  The company is at the leading edge of $1.3 trillion in junk debt coming due in escalating yearly amounts between now and 2020.  As the WSJ points out, TOYS’ experience in getting its refinancing done over the next two months or so will give an indication of how bumpy the road will be that other junk-rated borrowers will have to travel in the near future.

Although I worked side by side with junk bond fund managers for years, I’m not an expert.  Nor are many financings as cut and dried as the New Zealand one I described above.  But I have learned a bit over the years about human nature and about how financial firms work.  I’m convinced that a hefty chunk of the $1.3 trillion in junk where principal repayment is coming due over the net three years was issued with the expectation that refinancing would be necessary.  (I’m also confident that the offering documents contained a boiler plate warning about this possibility  …and that many buyers skipped over these pages, either from laziness or because they knew that was the way these transactions worked. )

Unlike the emerging markets debt crisis of a generation ago, I don’t think a potentially serious problem with junk bonds today is the same kind of threat to world economic growth that the 1970s lending crisis was.  But it could be a nasty bump in the road for junk bond funds and for the private equity firms that control companies who have been big junk bond borrowers.

We’ll know more in a month or two.

 

a footnote to yesterday’s post

Yesterday I wrote about the Third Avenue Focused Credit fund, which shut itself down amid a tsunami of redemptions.  (The SEC has since blessed its liquidation plan, by the way.)

Several thoughts:

–Typically, institutional clients abhor their managers keeping cash reserves.  Their idea is that they do the asset allocation, which they consider the brainy part of the business, and leave the details to the managers they hire.  They don’t want managers upsetting their asset allocation plans by holding more than a tiny amount of cash.  On the other hand, they want the ability to withdraw their funds instantly that the mutual fund/ETF form gives them.  Given that the majority of the shares of the Focused Credit fund were “institutional,” this may have been part of the fund’s problem.  In hindsight, the institutions should have had separate accounts to hold their money in.  On the other hand, it’s hard to turn down the cash that clients are pleading with you to take.

–One secret to investing is to ride your winners and cut your losers.  There’s a tendency for investors of all stripes to do the opposite.  Sometimes they even sell some of their good securities to buy more of their losers.  Don’t ask me why.  My only answer is that no one likes to admit he’s made a mistake.

In particular, when a fund sees redemptions coming, I think it must sell assets across the board, with particular attention to offloading the least liquid, most losery holdings it has.  Otherwise the fund ends up making itself less and less liquid.  If brokers figure out what’s going on, which they will surely do pretty quickly, or if another fund begins to sell, these less liquid holdings may become unsalable, except at crazy low prices.  (All a broker has to do is look at your latest SEC filings or your own marketing materials to learn in detail what you own.)

–Another secret to investing, especially applicable to value investing, is to buy low. Its corollary is to sell high. Both are much harder to do than most suspect.  In fact, stock market participants typically do the opposite.  Some fund managers will even use the flow of money into their funds (or lack of it) as a contrary indicator.  They adopt a bearish stance when they’re flooded with cash and become more bullish as the buy high/sell low crowd starts to leave.  Maybe you can’t hold cash, but you can hold some highly liquid, if boring, positions.

my takeaway

I don’t know the people at Third Avenue and have no idea how they handle management of their portfolios in general or how they dealt with redemptions at the Focused Credit fund.  Even if the managers did everything by the book, my guess is that the withdrawals were so overwhelmingly large that closing the fund was the only option.

The Focused Credit demise came during a period of economic expansion.  Yes, natural resources junk bonds have been in trouble, but the general economy isn’t.  I wonder what would happen to junk bond funds in an economic downturn?

 

 

 

 

Third Avenue Focused Credit Fund

a decision to liquidate

Last week the Third Avenue Focused Credit Fund (TFC), a junk bond fund managed by well-known value investor Third Avenue Management, decided to cease normal operations and liquidate itself.

The fund had lost about two-thirds of the assets it had at its high point to a combination of market losses and investor redemptions.  TFC apparently had reached the point where it determined it could only sell further holdings at big price concessions.

Rather than do so, the directors of the fund opted to stop honoring redemption requests, distribute all its cash on hand to shareholders and put the remaining fund assets into a liquidation trust.  Third Avenue is in the process of issuing shares in this trust to TFC shareholders, who will receive the proceeds of liquidation sales as and when they happen.

How did this happen?

According to the New York Timesthe lead portfolio manager of TFC was telling investors that everything was fine two months ago.

I’ve looked at the SEC filings for TFC since mid-2014.  Three things jump out at me (remember, though, I’m a stock guy, not a junk bond person):

–there’s no undue concentration in any industry or sector area (I’d suspected there might be)

–the percentage of assets classified as “level 3,” meaning basically that they’re being valued by a theoretical model rather than a daily market price, went from negligible in mid-2014 to about 20% of assets in September 2015.  I don’t know whether this came about through a change in portfolio strategy (which would strike me as odd) or whether it’s the result of liquidity drying up in the bonds TFC held.

–net assets were about $2 billion on September 30th.  According to the NYT, they had shrunk to $790 million ten weeks later.  That implies an avalanche of redemptions.

What caused the massive outflow?

Who knows.  My only observation is that the majority of shares were “institutional,” which typically means each holder had at least $500,000 worth of shares.  Maybe a small number of them represented a large chunk of the fund’s assets and they all decided to allocate away from TFC during their year-end planning.

I’ve seen stuff like this happen before

In most of the instances I’ve observed, however, the fund is part of a large asset management group–a brokerage firm or a bank–that steps in and buys the illiquid assets at the fund’s carrying value, thus providing money to meet redemptions.  Third Avenue is apparently not big enough to do so.

lessons?

Not many.

Past junk bond crises have shown that this asset class is much less liquid than one might think.  Also, if things turn ugly it’s probably better to own shares in a fund with a deep-pocketed parent.

 

 

 

 

 

want index underperformance …try an actively managed bond fund

Indexology

‘For a while I’ve been following the Indexology blog written by S&P.

As the name and source suggest, the blog extolls the virtues of indexing–after all, S&P makes them and sells information about them.  I find the posts to be generally interesting.  My only quibble is that the Indexology people seem to be true believers in a strong version of the efficient markets hypothesis.  They’ve all drunk the Kool-aid and don’t stop to question how it can be that basically every professional active manager underperforms   …nor do they try to imagine what circumstances could create even a temporary burst of outperformance.

I’m well aware of all the figures about equity manager underperformance.  However, I’d never thought much about bond funds, the subject of the Indexology post of March 12th.

The numbers are stunning.

bond fund (under)performance vs. benchmarks

Here they are:

–in 2014, 97% of the government bond funds underperformed, as did 98% of the investment-grade corporate bond funds

–in both categories, over 95% underperformed over the past five- and ten-year periods

73% of the junk bond fund managers underperformed in 2014; over the past five years, 88% underperformed; over the past ten, the number is 92%.

Bright spots?:

–among actively managed senior loan funds (which don’t contain bonds;  they hold pieces of syndicated bank loans to non-investment grade corporate borrowers), 70% outperformed last year.  Over the past decade, though, underperformers and outperformers are just about equal in number.

–61% of municipal bond managers outperformed in 2014.  55% did so over the past fie years.  However, over the past ten, 70% underperformed.

reasons for this woeful showing?

Indexology offers none.  Personally, I have no firm ideas.

Looking only casually at the results of Bill Gross over his years at Pimco left me with two impressions of the former Bond King:

— he continually bet very aggressively (and correctly) that interest rates would fall–sort of like an intelligent version of Jon Corzine, and

–a large chunk of his outperformance disappeared through the high fees Pimco charged for his services.

Indexology doesn’t talk about fees, which can’t have improved the situation for bond managers generally–and I presume the Indexoogy numbers are after them.

The better areas for relative performance are smaller and contain less liquid securities.  I wonder what role pricing–which I presume is not based on daily trading but on the theoretical models of third-party experts–plays?

 

high yield (junk) bonds (ii)

what went wrong

1.  Junk bonds began to be used as a substitute for bank financing–but to a large degree by takeover specialists targeting either mediocre industrial companies or consumer staples firms of any stripe.  In both cases, more efficient management would boost cash flow enough to service the massive debt incurred in the acquisition.  Fear of the required debt service would act as a powerful motivator toward greater profitability.

Arguably, the substantial change of control among underperforming companies during the 1980s that junk bonds made possible laid the groundwork for the industrial renaissance the US experienced in the early 1990s.

Nothing wrong with that.

But in some cases, rapacious acquirers went further.  They targeted well-funded employee pension plans, replacing a conservative investment menu with a diet of exclusively junk bonds.  Others, particularly in the natural resources area, forced the acquired firms to operate for maximum near-term cash generation.  Timber companies, for example, harvested 3x-4x the usual number of trees every twelve months–leaving no time for replacement trees to grow.  As a result, companies went out of business; employees found their pension plans, after the junk bond collapse, unable to meet obligations.  The acquirers just walked away with the cash they’d drained from the firms.

Drexel also pleaded no contest to SEC charges that it illegally supported acquirers through stock manipulation and by helping them avoid 13-D reporting requirements.

2.  By the end of 1986–maybe a little later–Drexel and Milken had done all the junk bond/leveraged buyout deals in the US that made any economic sense.  What to do then  …close up shop or continue to do junk bond deals, even though they made no sense and might ultimately fail.  Drexel/Milken chose curtain #2.

By early 1989, the consequences were becoming evident.  Junk bond default rates were rising sharply, depressing junk bond prices.  To my mind, October 13th of that year marked a tipping point.  That’s when the media reported the failure of a proposed $6.75 billion leveraged buyout of United Airlines.  This was the first big junk bond deal not to get done.  Psychology changed decisively for the worse.

That’s when retail investors, who had been sold junk bonds on the idea that they had all the return potential of stocks plus all the safety of bonds, found out their dark side   ..if nothing else, how illiquid they are.  Junk bonds fell, on average, by about 30% in the following months.  Some investors also found out, to their sorrow, that up until that time their mutual funds had been pricing their holdings at what proved to be unrealistically high levels.

3.  We can all understand, though not condone, why Drexel/Milken would want to continue to sell dud junk bonds.  It’s what they did.  But why would any professional buy them (I know I characterized bond fund managers as not being among the best and brightest in my Friday post, but you;;d think they’d catch on eventually)?

The Federal government had an answer.  It was that Milken and Drexel bribed prominent junk bond fund managers to look the other way and take part in bad deals for their clients.  The Wall Street Journal had an in-depth investigative series on this issue in 1990.  I’ve been unable to find in the the WSJ online archives, however.

The government was unable to prove its case.  A New York Times article and one from the LA Times that describe the charges are the best documentation I can find.

Personally, it feels to me that the government was right, but that it had no way of getting any of the small number of people who would have been involved in a scheme like this to testify against themselves.

still, a revolutionary idea

By the early 1990s, the junk bond market had revived, though on a firmer footing as a result of the government action.

high yield (i.e., junk) bonds

Addled perhaps by too much turkey and a football triple header, I’ve decided to write a (very) brief outline of the development of junk bonds .  Today’s post is the first of two installments:

The first junk bonds were “fallen angels,” that is, corporate bonds that were investment grade when they were issued but whose credit ratings fell as the issuing company encountered difficulties and its finances deteriorated.

In an investment banking class in business school in the late 1970s, I heard a speaker from Drexel Burnham Lambert, the junk bond kings, deride the corporate bond establishment as a bunch of clubby coupon-clipping Ivy Leaguers without a brain among them, who simply sold such poor-performing bonds without analyzing the underlying fundamentals.  Drexel, he said, thanked God for creating these slackers, whose pockets they picked daily.

He then gave an example of a small oil exploration company that was in the midst of a sharp positive surge in profitability but whose bonds were still priced as if Chapter 11 loomed the next day.  As it tuned out, working as an equity analyst, I covered the company he mentioned.  Everything he said was accurate–and apparently unknown to the general run of bond managers.

The problem with the Drexel business at that time was that you used up the available pool of fallen angels pretty quickly.  How did you make money then?

The innovation of evil (and I do mean evil, despite the SEO puffery you see if you Google his name) genius and convicted felon Michael Milken was to realize Drexel could offer junk bonds as original issues.

Companies with less than pristine credit were already getting financing from banks, which were making a fortune on the business.  They were taking in retail deposits that they paid, say, 3% interest to customers on–and lending the funds to sub-prime corporates at, say, 12%.  To state the obvious, that’s a gigantic spread.

Suppose, Milken, thought, Drexel were to float bonds for these companies at 9% instead and market them to junk bond mutual funds + pension investors.  Retail investors would get around an 8% yield after fund expenses, the companies would get a cheaper interest rate, Drexel would collect enormous investment banking fees.  Everyone, ex the banks, would be happy.

The banks would be “disintermediated” (cut out of the action), as the term goes, in the same way as money market funds were cutting them out of the market for time deposits.

As it turns out, there was another gigantic plus for the issuing companies.  The junk bond fund managers appear to have had either terminal brain freeze, clubby Ivy League bond backgrounds, or absolutely no prior experience in corporate lending.  Cluelessly, they failed to require that the junk bond issues they bought have any of the protective covenants that Banking 101 would have taught you to demand.  No wonder sub-prime issuers were chomping at the bit to obtain Drexel’s underwriting services.

More on Monday.