Sunday, August 30, 2009

Death of a Model?

While the Chicken Littles of the financial world have been relatively quiet in the past few months, there continue to be pockets of anxiety. Perhaps the name most mentioned in the past few weeks is CIT.

This relatively obscure financing company deals in what they call “middle market business and commercial loans, financial services and solutions”. So we’re talking about Small Business Administration Loans, Factoring (lending with receivables as collateral), leasing, etc. Middle sized companies, like retail chains, service providers and specialty manufacturers turn to these guys for money. On the consumer side, they finance student loans.

So basically no “mortgage meltdown” here, although the recession has affected their loan and lease portfolio and write-downs put the company’s results into the red for the last few quarters (not unlike most financial institutions). CIT received TARP money last year (again…like everyone else).

The balance sheet appears to be solvent, with $64 billion in liabilities to $6.1 billion of equity. Hardly levered compared to most, you could say. Cash flow is quite positive.

Nonetheless, CIT tethers on the edge of bankruptcy. Why?

The problem is funding. For years, CIT has financed its operations by issuing notes and commercial paper to the “market” and then using those proceeds to lend out. They call it the “wholesale model”. Get money in the market at 4, 5, or 7%, lend it out at 9-12% effective rate. Live happy ever after.

Of course, something happened on the way to the bank (or middle market finance company). The credit freeze happened. All of a sudden the “market” for CIT’s paper was no longer there. CIT did a few things, like issuing commercial paper with a government guarantee (for a while) and converting to a bank holding company, which allows it to get FDIC-insured deposits. Additionally, CIT reduced its portfolio (essentially lending out less than it was collecting).

But it hasn’t been enough. Notes issued in previous years are coming due at a quick pace ($13 billion for the next 12 months). Funding has not been forthcoming quickly enough (deposits at the CIT bank are only $5 billion). At least not CHEAP funding.

There is a price for everything and CIT recently got a SECURED $3 billion credit line from Barclays and a syndicate of banks. But at a price: LIBOR plus 10%, with a 3% LIBOR floor. (That’s a 13% floor and there are other fees associated,too). They got some of the cost back buying back some notes at a discount, but it doesn’t offset that much.

This is obviously not a permanent solution. CIT can’t operate funding at over 13%. And of course, while its liquidity problems remain, it can’t fund cheaply. S&P already has them at CC.

It’s a catch-22. CIT can’t get the money it needs because it has no money. Rinse, lather, and repeat. Can the “wholesale model” escape this circle?

Of course, CIT itself is lobbying quite clearly for a bailout. Just check out its website. HERE. They have a point. How is CIT that much different from another banking holding company (Citi? Morgan Stanley?) or GE Capital for that matter (GE continues to get TALF support). On the other hand, shouldn’t the “market” have a market-based solution for this?

If CIT is indeed solvent as it’s balance sheet indicates (you can never be sure), shouldn’t there be a buyer for it? And also if so, shouldn’t CIT be able to return to its original business model (selling notes at “normal” yields).

Of course, there is an investment opportunity here. These “survival” plays tend to carry a very interesting risk/reward ratio. CIT’s stock has been volatile for sure. But a bailout could carry a hefty price in terms of dilution, so no simple solution there. Potentially large payout, however, CIT trades at a market cap of only $600 million (excluding the TARP money…which could convert).

And there are bonds, of course. Bets on “survival” generally have worked well since Lehman collapsed last year. Solvent companies with liquidity problems can find buyers (as was the case with Nova Chemicals) or a government hand if they are “too big to fail” (Banks, AIG and subsidiaries) or something in between (Ford Credit. GMAC).

In any case, CIT paper maturing in the next 2-4 months is trading at 60-70% of par. Putting down 60 with an upside of 100 in a few months, with only one major outcome in play (survival), is a tempting bet. In the case of bankruptcy, CIT’s long-term notes, trading at around 45-47%, would seem to indicate that the expectation of recovery is relatively high.
So overall, I kind of like those “pot odds”.

Friday, August 21, 2009

Fun with Standard and Poors

On Tuesday (Aug 18) S&P downgraded the debt of homebuilder Beazer Homes (BZH) to “SD” or selective default. Two days later, the homebuilder’s credit (but not its bonds) was upgraded again to CCC, or basically where it was to start the week.

Before you say “whaaa”, lets just say that there is a reason behind the madness. What happened was that Beazer, seeing that its notes were trading below 50%, went out and bought a chunk of them back at those distressed levels. They invested $54 million to buy back $116 million worth of notes due in 2011-2016. Financially it makes a lot of sense, since they’re buying back bonds with yields of 30-50%. They’re not going to make that kind of cash building homes. Not these days, at least.

Well, S&P doesn’t like that very much. They call it a “selective default”. Basically, the company is taking cash on which all creditors have a claim and giving some bondholders (the ones selling) an early payment, while others get nothing. But you can also argue that by retiring debt at such a deep discount, the company puts itself into a better position to pay all creditors down the line. The market tended to agree with the latter assessment and Beazer bonds have rallied from as low as 22% at one time to 60-85% (depending on maturity).

As a (happy) holder of Beazer bonds, I don’t mind this kind of transaction, since it certainly beats other options available to distressed companies. Those usually involve issuing high-yielding secured debt, which basically puts itself in front of the creditor line and pushes us unsecured creditors down. S&P and Friends, on the other hand, don’t mind those as much.

Of course, S&P didn’t find out about these purchases until Beazer published its quarterly report (10-Q) a few days ago, and when they did, they proceeded to downgrade, but only for two days, since the fact is that the bonds outstanding are not really in default (and most probably are in a slightly better position to be paid).

This kind of thing happens in the strange world of debt and not only with obscure names such as Beazer. Earlier this year, Ford saw that its bonds were trading around 20% and instead of trying to purchase them in the market, decided to launch a tender at 30%. It was a total success with $9.9 billion in notes bought up by the carmaker. LINK. There was even a small arbitrage window, as those bonds traded around 20% for a few days AFTER the tender was announced (thank you, Ford!).

S&P weighed in to say “naughty, naughty”, but still had to reverse the downgrade a day later.

As for those bonds? Now trading around 70-75%. “Selective Default” indeed!

Disclaimer: I own Beazer and Ford bonds.

Tuesday, August 18, 2009

Love Me Tender

It’s always flattering when someone comes up to you and makes an offer for something you own, even if you weren’t intending to sell it.

Well, bond investors are being flattered enough to blush lately as a spate of tender offers has hit the markets in the past few months.

Here’s what’s happening:

When credit markets “froze” up last year, so did the market for new bond issues. Companies, which were looking to refinance to improve their maturity profiles or simply raise capital for some corporate purpose, were essentially locked out. And we know what happened to the secondary market.
When your “old” bonds are yielding in double digits, who is going to buy some new, probably longer dated ones, at a lower rate. So very few new issues hit the market.

But as the markets have thawed, it has enabled issuers to come to market, selling new longer-dated bonds at “decent” rates and usually accompanying it with an offer to repurchase some outstanding shorter dated.

Just to name a few issuers doing this: International Paper (twice!), Owens Illinois, Corrections Corp of America, Centex/Pulte.

Now a couple of examples to understand that mumbo-jumbo.

Two weeks ago, Jabil Circuit issued $312 million of 7.75% notes at 96.143% (yield 8.50%). Here’s a Link.

At the same time, they offered to buy back the $300 million outstanding of their 5,875% July 15, 2010 (that’s less than 1 year) notes for a “total consideration” of 103.125%. That price is equivalent to a yield of only 2.45% for the remaining term of the bond. LINK.

As a happy owner of the 2010 notes, I was glad to turn them in a year before I expected to collect (2.45% doesn’t meet my yield threshold…might as well pay down my mortgage).

So why would Jabil issue notes at 8.5%, to buy back an equal amount of notes at 2.5%? Well, obviously they want to extend maturities. The market is quite open right now for new issues and they can’t assume it will necessarily stay that way. It’s an extra $18 million in interest expense for the year for a company that only earned $157 million pre-tax in its last full fiscal year. The comfort that liquidity offers comes at a hefty price.

The holders of the 2010 note had a relatively easy choice. Accept the attractive tender (98% did accept) or keep their 5.875 % note and collect the principal next June. There is little doubt they will be paid. The 2010 bond will obviously have reduced liquidity now, but frankly, most of these notes are bought to be held to maturity.

Of course, once Jabil pays for the tendered bonds, what do you do with the money? Well, the Jabil 2016 notes don’t look too bad (can you get me some?).

Another recent example is Brunswick Corporation (bowling, marine equipment). Brunswick, being heavily in the non-discrectionary consumer category, is having a hard time with the recession.

The folks at Brunswick sold $350 million of 11.25% SECURED (i.e. collateralized) notes due 2016 at 97.036% (yield 11.89%) and have tendered for $150 million of their 5% June 2011 notes. They’re offering 97% for the notes, plus a 3% “consent fee”, for a total of 100%. LINK

No premium this time, but I’ll be tendering happily again since this credit was making me a bit nervous. The terms that Brunswick has paid to make the new bond happen, clearly shows that others are a bit skittish also.

In any case, I can’t buy the new issue, since it is a Rule 144A/Reg S. Non-US persons can, but frankly I’m not recommending this risk right now.

Although at some times its hard to say goodbye to a bond for which a tender has been made, it also allows you to adjust your portfolio and move to a more profitable section of the yield curve. Selling those notes with 1 or 2 years left and where most of the profit has been made –with very little cost-, is a great deal.

So for now…keep ‘em coming. I’m loving these tenders. On the other hand, the bond calls…well that’s another issue. (and another post).

Wednesday, August 5, 2009

Too Good to be True?

Corporate Bonds have gotten quite a bit of ink lately.

Here’s a link from Reuters “Nonstop corporate bond rally raises eyebrows"”and the more sensational headline from Bloomberg "Junk Bonds Make Loomis Sense Dot-Com-Like Danger”. Take some time to read those links.
Don’t panic, yet.

Basically, the storyline is “Hey, look at this great rally we all missed”. Since we all missed it, it has to stop. It’s a bubble, help us!

Or something like that.

As a confessed bond junkie (bond junker?). I’ll admit that things have been good. Unexpectedly good. Historically good.

Not unlike the equity markets, the rebound of the bond market has been fast and furious. Perhaps even more furious than stocks. According to the Reuters article July was the first month in many in which stocks outperformed bonds.

Here’s a graph from the St. Louis fed showing the yields of Baa rated (Moody’s – think BBB for S&P).

Since prices move in the opposite direction as yields, prices have been shooting up as those yields have collapsed. The move in junkier bonds has been even more dramatic.

Which is good, but it’s also bad because unlike stocks (remember the dot coms), bond prices are bound by rational limits. A risky (non-treasury) bond should not trade a yield below the corresponding treasury of the same duration. And of course, it makes no sense to buy a bond with a negative yield.

Treasury yields have trended up, as evidenced by this nice graph of the US yield curve.

Bond yields collapsing, treasury yields rising, spreads (the premium over the treasury yield) falling .we’re in for trouble, right?

Not so fast. Here’s a practical example. Let’s say back at the end of April you decided to buy some Alcoa 6% July 2013 at 92.75%, to yield a solid yet unspectacular 8.2%. Not bad for 4 years and Alcoa isn’t an extreme risk (BBB-, just what they call “investment grade). Good for you.
Today that bond is trading around par (100%), yielding 6% to maturity and you’ve made more in a single quarter (9.4%....the 1.5% coupon plus the price appreciation of 7.8%), than you expected to make on average in a year of holding the bond. Time to take profits and move on, right?

Well sure…you can sell. And do what exactly with the money? Put in in CDs? You’re lucky to get 1% on a three-month CD and 3% on a 5-year one. Treasuries? 2.63% for 5 years.
Less yield, lower risk.

You could increase risk, moving down in credit quality or longer in duration, looking for a bigger payout. Higher yield, higher risk.

Or you can stay put, which makes a lot of sense. First of all, because 6% YTM ain’t bad for 4 years and second because ot the shape of that yield curve.

The yield curve is seriously inclined and looks to continue to be that way for a while, even if it does move around a bit. For argument’s sake, let’s say that Alcoa’s spread vs. treasuries remains the same a year from now (330 bps) and that the three yield treasury remains at 1.66%. The bond would yield about 5% and trade around 102.75%.

So…it nothing changes and you wait a year on the bond, you’re looking for 6% in interest and 2.75% in capital appreciation over the next year. 8.75%!!! Not bad.
Sure, things can move, but as of now 8.75% is your base scenario for the next 12 months, not 6%.

That’s how powerful that incline in the yield curve is.

So, yes…this may be the beginning of a bubble. And yes, it the market has run quickly and far. And yes…this is like a bargain basement, all the good stuff gets picked up first (and is gone now), so you have to rummage through the bins to find value.

But when the yield curve is like now, think of how much fun it is to “slide down” as if it were a water slide.

So for now, I’m still buying bonds, and selling the bubble story.