'Will The Horse Finish The Race?' (Some Insights Into Credit Risk)

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Includes: ECC, FGB, OXLC
by: Steven Bavaria

Summary

Making "equity" returns investing in DEBT rather than EQUITY is safer than many investors think.

The words "High-Yield Credit" scare the dickens out of some investors who think nothing of investing in mid-cap or small-cap stocks, virtually all of which are non-investment grade.

Yet whenever you invest in the equity of a company, you are ALSO taking its credit risk (If a company fails to pay its debts, its equity is worthless).

The GOOD NEWS: when you look at the stats, high-yield credit investing is not so scary after all; many would argue it is LESS risky than equity.

NERD ALERT: This article is a bit WONKY.

For several years (including recent articles here and here), I have been describing my strategy of using credit markets as an alternative to equity markets to achieve "equity returns," which I define as long-term total returns of plus or minus 10%.

I pick 10% because (1) that is approximately what the S&P 500 has earned on average since 1928 so it makes a good long-term proxy for a generic "equity return," (2) it is a rate that would double an investor's money every 7 years, making it an appropriate target for long-term investors whether in their 20s or already retired, and (3) it is a yield (and therefore, a compounding rate) that is readily achievable using closed-end funds and other high-yielding investments available to retail investors.

Invariably, when I describe my investing strategy of using high-yielding, credit-risk- oriented securities as my asset class of choice (instead of traditional equities), I get variations of: "Isn't that awfully risky?" or "How can you buy high-risk, non-investment grade debt?" and similar concerns.

What then follows are long strings of comments and questions about:

  • The difference between equity risk and credit risk (i.e. the nature of the credit risk "bet" and the equity "bet."
  • How credit risk and interest rate risk vary considerably among different types of bonds and loans (and lots of investors don't appreciate the difference, or what they're actually betting on).
  • The ins and outs of credit ratings.
  • Differences between investment grade and non-investment grade.
  • Difference between "default risk" and "repayment or recovery risk."

Since so many of the same questions come up over and over, and frankly because I find this stuff fairly interesting, I thought it might be useful to write an article just focused on many of the aspects of credit-oriented investing that underlie my investment philosophy.

Many investors who are accustomed to taking equity risk find credit risk disturbing or scary, in part because they don't understand it or are not as familiar with it. But for many of us who have been trained in it (like most ex-bankers or others denizens of the credit industry), credit risk can actually seem less volatile and more capable of being modeled and predicted than equity risk.

In addition, it has the added advantage that you get virtually all your total return in the form of current interest payments (cash in hand, immediately compoundable) rather than having to wait for the return in the form of future growth in market price and/or dividend payments.

I know many readers are intrigued by the fact that I can achieve the same sort of long-term return that a typical "dividend growth investor" makes on a portfolio of lower-yielding (say 3-4%) stocks that grow by 6 or 7%, by investing in a portfolio of high-yielding (9 or 10%) stocks and funds that have no growth potential at all, by compounding the cash income regularly.

While the math is obvious, some readers think the higher yields must mean a greater degree of risk, compared to holding stocks. For some, this objection is almost akin to a religious belief, and those readers I do not expect to convince. For others, this article may fill in some gaps and provide a few insights about credit and related risks that are not so intuitive.

So let's walk through some basic concepts about credit, credit risk and how it affects our portfolio expectations:

Credit risk is the risk of lending money to a company and not getting paid back. It is basically betting that a company will stay in business indefinitely and pay its debts and other bills as they come due. You take this risk when you extend credit by buying a company's bonds or loans.

All equity investments include credit risk as a matter of course, in addition to the additional risk of being a stockholder. That is because if a company doesn't stay in business and pay its debt, then obviously its stock, which ranks lower than its debt, will have no value whatsoever.

But for that equity investment to have value, the company has to do even more than just stay alive and pay off its debt. It also has to grow and thrive, or else its stock will provide little return. So unless I get paid MORE to take the risk of owning equity, I'd rather hold the debt. (As readers know, I often compare the difference between buying equity and buying debt as "betting on the horse to win, place or show, versus betting on it to merely finish the race.")

Government and investment grade bonds pay you mostly to take interest rate risk, not credit risk (10-year treasuries - 2.15%, virtually all interest rate risk, since the government can print the money to pay off the debt; corporate investment grade bonds at 3 or 3.5%: you're only getting an extra 1% or so for taking the credit risk of a corporation instead of the government.

Hence, there is no "equity return" in investment grade credit. If you want an "equity return" in credit, you have to move into high-yield credit, which means non-investment grade.

That may scare some investors, but it shouldn't. If you are investing in a mid-cap or small-cap equity fund, you are already taking high-yield credit risk. The average credit rating of all US corporations is double-B, so the average mid-cap company is probably in that category. The average small-cap is probably closer to a single-B. (S&P 500 companies, by comparison, average triple-B, which is the lower end of investment grade.)

Since equity is ranked lower than debt on the liability side of the balance sheet, unless a company stays alive ("finishes the race") and pays its debt, its equity is worthless. So when you "bet" on the equity of a small cap or medium-cap firm, you are making a credit bet as well as an equity bet.

So if I can make my 9 or 10% "equity return" by investing in debt that's higher up the balance sheet hierarchy than equity, why take the extra risk? In other word, why make two bets if I can get paid just as much for only making one?

Bonds or loans?

In the closed-end fund world, there are lots of high-yield bond funds and senior loan funds, as well as a number of "multi-sector" funds that own both. Knowing the difference between high yield bonds and loans is important. Both can be attractive, but for different reasons.

High-yield bonds are unsecured, sometimes even subordinated, so they are junior in the event of default to senior loans and other secured obligations (like mortgages, etc.)

Besides being secured by collateral, loans are also typically floating rate, with rates adjusted usually every three months at a pre-determined spread over LIBOR (e.g. a riskier single-B or triple-C credit would pay a larger spread above LIBOR than a less risky double-B)

In short, loans - secured by collateral and floating rate - are safer than high-yield bonds - unsecured or subordinated, and fixed rate, even though both are made to the same cohort of non-investment grade companies. In fact, many large companies will have both a large syndicated senior loan and a usually smaller unsecured or subordinated high-yield bond as part of their liability structure.

It is relatively easy to calculate how much safer senior secured loans are than unsecured/subordinated bonds (even setting aside the interest rate risk aspect of fixed vs. floating rate). Because bonds and loans are made to the same basic cohort of companies, they tend to default at the same rate. Double-B companies have historically tended to default at a rate of about 7% over a period of five years.

If a company defaults, it usually defaults on all its debt at once; especially since most loans and bonds have cross-default provisions, where if you default on one instrument the other also is declared in default. This protects holders of each class of debt by allowing them to take preemptive action rather than having to sit idly by while the issuer defaults on the other debt, even if it's managed to keep up the payments on the debt you are holding.

But AFTER the issuer defaults, secured loans are first in line, for payment ahead of the unsecured or subordinated bonds, which makes a big difference in the amount of loss a holder ultimately suffers. Let's look at the double-B companies referred to above. Historically, a portfolio of double-B rated corporates will experience defaults of about 7% over a five-year period. (Really interested in this stuff? Check out S&P's 35-year default study, and similar data, by Googling "S&P Default Studies.")

Historical studies show that secured loans tend to recover about 75% of their principal (on average; it's skewed so most recover closer to 100% and a few don't do nearly so well, so diversification is critical), while unsecured or subordinated bonds on average only recover about 30% or even less (the subordinated ones recover less).

That means that while your loan and bond portfolios may default at the same rate, your portfolio credit losses will be quite different. How different?

Imagine the secured loan portfolio of double-B credits where 7% of your loans default over 5 years and you recover 75% of your principal (i.e. lose 25% of it). Your losses over five years will be 25% of 7% of your portfolio, or 1.8%, spread over 5 years: 0.35% per year.

Imagine that same portfolio but you bought the bonds instead of the loans. Your defaults are still 7% of the portfolio but now you lose 70% instead of only 25% on the deals that default. That's 70% of 7%, or 4.9%, spread over 5 years: about 1% per year.

The credit cost to the high-yield bond portfolio is three times as much.

But neither one is that big a hit when you are talking about the relatively modest default rates of double-B credits.

Now imagine a portfolio of single-B credits, which historically have defaulted at a 5-year rate of 18%, over twice as high a rate as double-B's.

So to calculate losses for secured loans, we'd multiply that same loss-in-the-event-of-default rate of 25% by the much higher default rate of 18%, to get a projected loss of 4.5%, or just under 1% per year.

For the unsecured/subordinated bonds, of course, the losses will be higher, since the 18% of bonds that default will suffer losses of about 70% each, for a portfolio loss of 12.6% over 5 years, or 2.5% a year.

This is a lot of numbers, but the basic point is that seniority and collateral make a huge difference, which is why you can expect a portfolio of high-yield bonds to consistently have credit losses of about three times as much as a similar portfolio of secured loans ("similar" in terms of credit quality of the issuers of the bonds and loans; i.e. comparing loans to double-B issuers to bonds of double-B's; secured loans to a portfolio of triple-Cs might well have higher credit losses than unsecured bonds to a portfolio of double-Bs, but that reflects the fact that the triple-C portfolio would have four or five times the number of defaults; the percentage loss per default would still be less for the secured loan portfolio).

Conclusions from all this:

Loans have less credit risks than bonds, and even loans issued by riskier companies (those with lower credit ratings) are not as risky as they first appear because of their seniority and collateral protection.

This is why senior secured loans make excellent assets for collateralization in leveraged vehicles, called collateralized loan obligations (or "CLOs") of the sort held by closed-end funds like Eagle Point Credit (NYSE:ECC) and Oxford Lane Capital (NASDAQ:OXLC).

Their good credit protection, along with their floating rates (i.e. no interest rate risk), is why senior loan closed-end funds, of which CEFConnect lists over 25, have become so popular, with yields in the 5 to 9% range (depending on the credit selectivity of the portfolio managers and the amount of leverage the fund has) and often available at discounted prices.

One of the developments in recent decades that has allowed the loan industry to develop into its own separate "asset class" has been the development of credit ratings on the loans themselves, rather than just on the companies that issue them. For an interesting and somewhat humorous view of how this development occurred, and the role played by one of the titans of Wall Street in prompting the change, see this article.

Loans and bonds from "high-yield" issuers are not so scary, and are certainly less risky than buying mid-cap and small-cap stocks that are issued by the same non-investment grade cohort of companies.

For me, buying a portfolio of high-yield credits where I earn yields in the 7-10% range, knowing there might be credit losses in the 1-2% range, on average, seems like a better deal than buying investment grade bonds where the entire yield, even if there are no credit losses, is only 2 to 4%.

For ideas of specific high-yield investments, including funds that own senior loans and bonds, but also other mostly credit-risk-oriented investments (e.g. shares of business development companies like those held by one of my favorite closed-end funds First Trust Specialty Finance (NYSE:FGB), see my most recent portfolio review articles, like this one.

Disclosure: I am/we are long FGB, OXLC, ECC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.