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.

 

Toys R Us redux

Toys R Us (TOYS (not a ticker symbol today)) has been an iconic name in retailing over the past forty years.

–In the 1970s urban department stores came under attack by upstart specialty retailers who extracted the most profitable “departments” from the older merchant conglomerates and opened stand-alone locations focused on a single line of goods in direct competition with their older rivals.  More nimble, with a wider selection, often lower-priced, more willing/able to follow customers to the suburbs, specialty retailers ate the department stores’ lunch for years.  Many still do.

Toys were at the top of the extraction list.

TOYS was the first of the three contenders (the others were Child World and Lionels Kiddie City) to complete a nationwide retail network yielding the economies of scale that eventually won out against the other two.  As such, TOYS is a textbook case of the successful 1980s retailer.

It took market share both from department stores and mom-and-pop toy retailers.

–The 1990s saw the rise of Wal-Mart (WMT) and Target (TGT), who, more modern versions of the department store, used their floor space in a flexible way than their predecessors.  Their toy departments were relatively small for most of the year, but expanded dramatically during the holiday season–meaning, in contrast to TOY, they had toy overhead expenses for only a small part of the year.  Because they had other lines of merchandise to sell, they could (and did) use the hottest toys as loss leaders, as well.

For the first half of the decade, TOYS steadily lost market share to WMT and TGT but made it up by taking share from mom and pops.  Then there were no more m&ps   …and TOYS’ underlying competitive issues became more evident (there are a lot more wrinkles to the story–like store locations–but I think WMT and TGT were the main plot line).

–In 2005, TOYS was taken private in the first of a series of attempts to reorganize or restructure the firm to restore its past glory.

 

today TOYS is back in the news as markets worry about the firm’s ability to refinance its substantial junk bond borrowings.  It’s now being looked at as a possible canary in the coal mine for future troubles in sub-prime debt.

More tomorrow.

 

 

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.

 

 

 

 

 

bond funds when interest rates are rising

This past weekend, the Wall Street Journal published an article in its Business and Finance section about what happens if interest rates rise and holders of bond mutual funds and ETFs start to sell in large amounts.  The article is based on a research report written by Barclays and co-authored by that firm’s co-head of fixed income research, Jeff Meli.  The article isn’t identified further.

Maybe that’s not so strange, since, as reported in the WSJ, I find the research itself to be weird.  Its conclusions seem to me to be either not that relevant or just plain wrong.  The article does, however, touch on a number of points that are important for bond fund holders to consider.

 

The report starts out by assuming what I guess the researchers think is a worst-case scenario:  the junk bond market drops 10% in a day, and a given mutual fund receives requests for redemptions equal to 20% of its assets.

It concludes that:

–the fund’s net asset value would fall by 12%

–the fund would sell its most liquid assets to meet redemptions

–the remaining assets would be mispriced at a value higher than the value they could be sold at

–therefore, the first investors to leave would receive more than fair value and would be the best off; later redeemers would get less than fair value for their shares

–ETFs don’t have these problems and should be preferred to mutual funds.

my thoughts

I think this is a very unlikely set of circumstances.  The most damning constraint would seem to be the “single day” provision, which is intended to give the junk bond manager in question the least possible time to raise funds to meet redemptions.  However, the other two conditions haven’t come anywhere close to being triggered on a single day, either in the downturn following the internet bubble or during the 2008-09 recession.  Some kind of gigantic external shock to the economy would seem to be necessary for either to happen– not something specific to a given type of asset.

In such a case, it’s not clear that any financial markets would be functioning normally.  It’s conceivable that trading in many/all financial instruments would be halted until calm was restored.  So the pricing of a given junk bond fund would be a moot point.

For at least the past quarter-century, junk bond funds have generally been priced by third parties at “fair value.”  I’ve seen them work for illiquid stocks or for NY pricing of stocks trading abroad.  My judgment is that they work incredible well.  So I don’t think fast redeemers get the best pricing.  The opposite may well be the case.

Fund families have lines of credit that they can use to meet unanticipated redemptions.

No portfolio manager worth his salt is going to sell only the most liquid assets first.  On the contrary, it’s better to sell illiquid ones while there are still buyers.

In the past, big investment companies have ended up buying the most illiquid assets from junk bond funds they manage at a price determined by a neutral third party, in order to make redemptions easier and shore up confidence in the fund.

In general, fund management companies have no incentive to price a fund too high.  If anything, they should want to price it too low.  That way, they can send the extra to redeemers once they find their error.  No one is going to send anything extra back.

I don’t get the ETF stuff at all.

More tomorrow.

 

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.