Equity Returns for Loans? I Wonder...

by: Marc Gerstein

If you haven’t seen the Seeking Alpha article "Firesale Prices Could Mean Equity Returns for Loan Investors", check it out. It’s very thought provoking.

It suggests that one could achieve a 10 percent annual return by purchasing distressed CLOs (collateralized loan obligations) based on the following assumptions:

  • Price: 66 cents on the dollar
  • Nominal spread over LIBOR: 300 basis points
  • Assumed LIBOR: 2 percent
  • Holding period: 5 years
  • Average annual default rate: 10 percent
  • Average default recovery rate: 50 percent

Author Steven Bavaria provides a link readers can use to download a spreadsheet which allows them to plug in their own assumptions.

I did just that, lowering the recovery rate from 50 percent to 30 percent. That cut my annual return to 7 percent.

I agree with Bavaria’s point that 50% is already pretty draconian by most standards. But I can’t help recalling my experience as a junk-bond fund manager in the mid- to late-1980s. I saw recovery rates drop closer to zero more often than many of us imagined possible. Bavaria is talking about loans higher in the capital structure, but I wonder how good the security interests really are nowadays. Another consideration is that many Seeking Alpha readers emphasize equities, ETFs and mutual funds and are, hence, unlikely to purchase CLOs. So I really would rather do the analysis in the tier of capital structure that is more relevant to junk bond funds.

I also suspect that we could go a lot higher than 10 percent in terms of “trouble rate,” a phrase that may be more meaningful than “default rate.”

Default is a legal event. Back in the day, I learned (the hard way) how much pain investors could feel without the legal trigger of default ever actually getting pulled. In other words, a company might say: “We’re current on the debt now, but unless you do such-and-such to restructure the debt as we insist, we’re not going to pay the next coupon and we’ll file bankruptcy in which case you’ll be lucky to get pennies on the dollar who-knows-how-many years down the road.” Creditors stewed but caved in, lawyers immediately piled up billable hours, and voila, old debt agreements were replaced by new debt agreements that badly hurt creditors without every having triggered a default.

Using a 30% recovery rate, I can put the default-trouble rate only up to 17% before zeroing out the overall return.

The difficulty with this analysis is use of Bavaria’s annualized five-year figures. I’d be more inclined to front load the really horrible numbers into year one and maybe year two, and then think in terms of a recovery scenario.

Here are my revised assumptions:

  • Price: 66 cents on the dollar
  • Nominal spread over LIBOR: 300 basis points
  • Assumed LIBOR: 2 percent
  • Holding period: 2 years
  • Average annual default rate: 25 percent
  • Average default recovery rate: 10 percent

This gives me a negative one percent annual return for the first two years. To reach Bavaria’s targeted 10% annualized five-year return, we’d need to recover at an annual rate of 18 percent in years three, four and five.

If I cut the recovery rate to five percent and raise the default-trouble rate to 35 percent, we’d experience a minus 17 percent annual return for years one and two. Ouch! To reach the target 10 percent annual five-year target, we’d need to get an annual return of 32.7 percent in years three through five.

That seems like a pretty rugged assumption. But here’s some good news. If one wants to assume downside “outliers” (exceptionally, off-the-charts, bad numbers on the way down), it’s also reasonable to assume upside outliers when the recovery starts. On that basis, averaging 32.7 percent in years three through five could be quite do-able.

Again, most of us are not talking about CLOs. But it may be worthwhile to do some serious number crunching on junk-bond mutual funds or ETFs (get portfolio reports with current pricing; we need to know how far the bond holdings have been hit, and see what percent of assets are in troubled financial names), and, perhaps, publicly traded business development companies like American Capital Strategies (NASDAQ:ACAS).

Please do not take these as Buy recommendations. I haven’t done the number crunching yet. But for those who tire of watching too much football on TV, it might make for an interesting way to pass some time in the days ahead.