Reading Felix Salmon's follow up to the NY Magazine article on Investing in Toxic Assets prompted me to issue a rebuttal. If you are immediately afraid of investment opportunities based on media portrayal, this article is not for you. If you are willing to search through facts and perform simple arithmetic in order to out-perform the market, you may want to keep reading.
So.... what is toxic? Toxic to who? How does that impact making money? Let's pretend you are a bank who lends someone $100 at 6%. What is the best outcome that can happen? Well, you eventually receive your $100 back with the 6% interest. Simple economics of a bond, I know.
So one day after the credit crises and during the recession, the Bank wakes up and realizes it will not receive their full $100 of principal back. Let’s say that based on all available information they expect to receive $95 back. If this hypothetical example were a mortgage-backed security, it would be rated CCC by the rating agencies. If there is even one penny of principal not expected to be received, it is immediately a CCC. The CCC rating does not tell you whether the rating agency projects 99% of principal back or 1% back.
Now, let’s take this a step further and assume an investor buys this $100 loan for $62 dollars. What is the best scenario for this investor? Clearly, she could receive $100 back in addition to the 6% coupon. Now does it matter if she only receives $70 or $80 back? No, in fact depending on the holding period, that would still be a fairly attractive return on investment – not even taking into consideration the 6% coupon. Would this loan, that may only return 80% of the original principal back be toxic to a Bank who purchased originated it at $100? Yes. Is it toxic to the investor, who is indifferent to credit ratings, and receives more than her $62 purchase price? Absolutely not.
What does this have to do with TSI? They have spotted the very attractive opportunities available in non-agency MBS, and have made them a primary holding in their closed end TSI fund. Based on portfolio manager Jeffrey Gundlach’s conference call last week (according to memory), their average purchase price is $62 cents on the dollar. Let’s take a look at one of their top holdings:
This one is titled WFMBS 2007 - 8 2A10 – in other words a Wells Fargo mortgage backed security originated in 2007. It is currently rated a CCC by both Fitch and S&P. Remember, a CCC tells you that they expect it to receive less than 100% of principal – not how much.
If we look at the collateral statistics (i.e. – how each individual loan is performing, taken from Bloomberg), we will see that out of the 3,658 loans, only 6.5% are delinquent greater than 60 days. These loans have an average credit score of 744. Let’s assume that 100% of the loans that are greater than 60 days delinquent will default. Furthermore, the average 12 month severity is 40%. This means that ONCE a loan defaults 40 cents on the dollar are lost – so only 60 cents will be returned to the bondholder. Multiply 6.5% (the current delinquencies greater than 60 days) by 40%. That gives you losses of 2.6%. Would our bond take this 2.6% loss? No – we have 4% of credit support – meaning 4% of the deal is below us to absorb losses.
You might say that my math does not account for future delinquencies. You are correct. Now, let’s use a cash flow engine to compute the amount of losses to maturity. We will assume the economy does not recover and that defaults and losses will stay flat. What are the results if you run this out to maturity? It shows 0% of losses to this bond, with a Yield of 13.5% assuming a purchase price of $62.
Even if things get worse, look at the huge buffer the average investment has in this fund. In this particular bond, 94% of borrowers are current. After going through this recession, I believe it would be safe to assume that these 94% of borrowers are good credits. Even if a draconian situation were to arise, a huge margin of safety is built in due to the credit support and purchase price at a discount. Now this is the awful investing advice that the aforementioned blogger was ranting about? Despite being a different asset class, aren't these same principles of "margin of safety" employed by famous investors such as Buffett, Berkowitz, etc...? It's not that I think these skeptics are wrong, I just think they are wrong!
The average person does not have the time or expertise to understand this level of detail, but TSI has management that does, and they have produced alpha on a year in and year out basis.
Is this fund starting to sound attractive? We are not done yet, consider the following facts:
-TSI is trading at an 11% discount to NAV as of last week. Therefore, you are buying into to these assets at an even greater discount.
-They have a current borrowing facility in place to borrow at ~1%. Gundlach stated on the call that the average yield on this portfolio is in the 19% range. So on the borrowed portion; you are earning a significant arbitrage.
-They have targeted to pay-out a 7% dividend based on the NAV. Given the monster income they are generating, it could be reasonably concluded that they will pay out a special dividend in the coming quarters.
-Like any bond fund, there is interest rate risk. Should rates go up the bond prices will go down. However, if rates go up it will likely indicate that the economy is recovering which will lower defaults and severity – thus helping the fund in other aspects.
-I strongly encourage you to read the transcript of the TSI call from last week. He gives much more detail and granularity into the fund than this article.
In conclusion, this may or may not be a suitable investment opportunity for you. That being said, amazing opportunities like these are created when fear and panic cause investors to disregard this asset class based on the “toxic” label. The question remain, who is this toxic for?
Disclosure: Long TSI