How the “Worry Discount” Overcompensates Credit Investors (Like Us!)
[A more detailed version of this article, with additional data and references, was made available to members and free trial subscribers of Inside the Income Factory® on July 15th.]
A friend of mine, the head of a major corporate credit institutional investment firm, recently described how the average market price of sound corporate senior secured loans (i.e. “leveraged loans”) had currently fallen to 92 cents on the dollar.
These are the type of assets held by Senior Loan Closed-End Funds as well as Secured Loan Obligations (“CLOs”), the type held by funds we own like Eagle Point Credit (ECC), Eagle Point Income (EIC), Oxford Lane Capital (OXLC), XAI Octagon Floating Rate Alternative (XFLT), OFS Credit (OCCI), Ares Dynamic Credit (ARDC) and others.
An 8% discount suggests the market is pricing in 8% losses in corporate credit portfolios. It would make sense if we expect the recession or whatever is ahead of us to be much worse than the “Great Recession” of 2008/2009, which was so called because it was by far the worst economic downturn since the “Great Depression” of the 1930s.
But for those who only expect a garden variety recession, or even a “mild recession” as many economists I’ve read predict, 8% discounts on business loans currently in good health suggest real opportunities and attractive prices for more sophisticated credit investors.
To actually lose 8% on a business loan portfolio, you must have defaults of 20% or more. Indeed, loans to senior companies are secured by collateral, with a historical average recovery rate of 70% (i.e. an average loss of 30% on the defaulted loan). At this historical loss and recovery rate, a 20% default rate with 30% losses on defaulted loans would result in 20% times 30%, or an overall portfolio loss of 6%.
Even if you take a more pessimistic view of future recoveries on defaulted loans, as some analysts currently do, and assume only 60% recoveries (i.e. 40% losses), that would mean that a default rate of 20% would result in portfolio losses of 8%. (i.e. 20% times 40% = 8%). Thus, to justify a price discount of 8%, one would have to anticipate a default rate of 20%.
The default rate during the 2008/2009 recession reached around 10%. This meant, with a 70% recovery rate at the time (i.e. a 30% loss rate), that the overall portfolio loss of a typical business loan portfolio was 10 % times 30%, or 3%. (Put that in perspective, a 3% hit would have significantly reduced a loan portfolio’s income in a single year, but it wouldn’t even have dug into the principal.)
This means that the business credit market is pricing losses twice as high as those suffered during the “Great Recession”. This overstatement of potential loss has happened before, including during the 2008/2009 period itself, when sound corporate loans and bonds often sold in the 60-70 cents on the dollar range ( or even less). This meant, as we have described in other articles, that investors (funds, CLOs, institutional investors, etc.) could reinvest their loan and bond repayments from their sound and successful borrowers (i.e. i.e. almost all) in loans and bonds from other healthy borrowers at unbelievably low and advantageous prices. Then, when the borrowers repaid at par a few years later, the investors (who had collected inflated coupons initially, given the discounted prices at which they had purchased the debt) also collected large capital gains equal to the difference between the 100 cents on the dollar they receive at maturity, and the 60 or 70 cents they initially paid to buy the debt.
With corporate debt selling at very favorable prices and the spreads on this debt being wider by a few hundred basis points than they were a year ago, many credit investors see this as a very interesting.
Investing in credit: “Stock returns without stock risk”
Many readers will know that one of my favorite topics is how to get average annualized “stock returns” of around 9-10% without the volatility and unpredictability of owning real stocks. Part of what makes this possible is the misunderstanding by so many investors of what they are actually “betting” on when buying corporate credit versus corporate stock. For more on this topic, read this and also this.
At the end of the line: Whenever you buy shares of a company, you are not only betting that the company will prosper, increase its earnings and ultimately its stock price, but you are also making the more mundane credit bet that the company will service its debts, pay its creditors and – essentially – survive. In other words, whoever buys shares of a company also assumes all the risks of the investors who own that same company’s debt (loans and bonds).
Ironically, many small- and mid-cap stock owners swear they would never buy junk bonds, but own the equity of the same cohort of companies that issue so-called junk bonds. they even take on more risk than the holders of these bonds, which outperform them and will be paid first if the company goes bankrupt, before the equity holders receive a penny.
This has created and continues to provide investors with many opportunities in the credit markets, from the specific funds listed above to the business development companies like Barings (BDC) that I wrote about recently. , as well as other credit funds included in our model portfolios and other lists of investment candidates. (Here are also some additional ideas along these lines.)
Thank you for your interest and I look forward to your comments and questions.