Book Summary: Leveraged Financial Markets

Book: Leveraged Financial Markets

Author: William F. Maxwell, Mark R. Shenkman

Overview: In 2007, leveraged finance was 8% of total fixed income securities outstanding in 2007 (HY bonds at 2.8% with $864 bn outstanding, and leveraged loans at 5.3% with $1.64 tn outstanding). Until the late ’90s, leveraged loans were issued by banks and were syndicated to other banks. Once the documentation was standardized, the secondary market took off. Securitization in late ’90s and early ’00s also led to more interest in the product, while banks pushed the product due to lucrative fees. Default rates have tended to lag the economic condition (which makes sense, because in good markets, corporates can roll over their paper). CDSs have also grown, from actively-traded CDSs for 13% of HY issuers in 2007 to 40% in 2010, according to BofA estimates.

High yield bonds trade in the dealer market, and hence capital committed by the broker-dealers significantly influence trading volume. This has been impacted by shrinkage of dealer capital post the 2008 crisis (which led to consolidations and losses). The TRACE system (mandated by the SEC) has helped this problem somewhat but not nearly enough to avoid liquidity crises during choppy markets, as TRACE has lowered broker-dealer profit margins and they’re less willing to commit capital to secondary trading.

Role of Credit Agencies: Even investors who don’t need Credit Rating Agencies (CRAs) for any credit risk assessment use the ratings for internal or external VaR measures, and are used for financial contracts such as pricing. Credit ratings are accompanied by outlook (long-term) and watch (change in rating expected in the short term). An issue is called split-rated is Moody’s and S&P have different major ratings (between 1982-2004, the ratings were within +/- modifier 86% of the time , and often not a big problem unless the split-rating straddle IG and HY sectors). CRAs also have recovery ratings (of the issues), which is substantially different from the credit ratings.

Types of bonds: Zero-coupon bonds have no-cash pay for no more than five years (due to U.S. tax reasons), but the interest accretes at the stated interest rate, so that at maturity the repayment is larger than the initial gross proceeds. This is different from PiK where payments of interest are made in additional securities of the same class.

Redeeming Bonds: Typically, for approximately half the life of the bond, it is not callable (called the “no call” period, after which there’s a call schedule. An exception to this is the equity claw (usually 35% of the bonds can be clawed away from the proceeds of an equity offering); usually the call price is par plus coupon (108 for a 8% coupon note). Equity claw used to be restricted to public equity offerings, but now are prevalent even with the private equity market.

Leveraged Loans as an Asset Class: Loan market became a full-fledged capital market after adopting the market-flex language, which allowed them to change pricing based on investor demand, after this because a practice after the Russian debt default. Covenant-lite loans typically don’t have maintenance covenants, but still have bond-like incurrence covenants.

Types of fees:

• Commitment fee: used for undrawn revolvers; also called ticking fee for TLs prior to drawdown.
• Facility fee: charged on the entire committed amount instead of a commitment fee
• Usage fee: if drawn revolver falls below a certain amount
• Prepayment fee: used for TLs
• OIDs vs. up-front fees: OIDs are usually seen in more challenging market, and up-front fees are more issuer-friendly

Mandatory Prepayments:

• Excess cash flow: usually 50-75%
• Asset sales: typically 100%
• Debt issuance: 100%
• Equity issuance: usually 25-50%

Credit Analysis:

There are four key focus areas: business risk, financial risk (with added focus on asset coverage and claims priority), management/ownership risk, and covenants.

• Management / Ownership risk:
  • The PE sponsor may be driving the company much more than the management and it is important to know how the sponsor tends to run its companies.
  • If the owners have little capital at risk (having taken most of their capital out), they might try a “swing for the fences” strategy, which may not be ideal for the bond-holders.
  • Financing philosophy: is the management comfortable with high levels of debt?

Bond Indentures

• Restricted Payments: do not limit capex or acquisitions, both of which should ultimately result in incremental cash flow. Usually, they allow RP is total restricted payments are < (a) RP basket + (b) carve-outs, AND (i) if RP will not cause default, and (ii) issuer can issue at least another $1 of debt under the debt incurrence test, though RP can be made under carve-outs even if the issuer fails the incurrence test. Generally there are two types of basket calculation: (i) 50% of cumulative net income (usually allows add-backs for events such as contributed equity), or (ii) excess of 1.5x cumulative interest payment.  Payments of divined in issuer’s own stock is often permitted, but not disqualified stock that may have debt-like mandatory redemption provisions or maybe subject to maturity prior to the bonds. One can also find significant exceptions in the definition of Permitted Investments (such as as a certain $ amount in JVs).
• Change of Control: 101 take-out kicks in with any of the following events: (i) any person other than permitted holders own >50% of the voting stock (can be 35%, which is the de facto controller, in some cases), (ii) majority of the BoD cease to be continuing directors, (iii) merger or consolidation with another entity, unless pre-M&A owners continue to own >50% of equity, (iv) liquidation/dissolution of the company. This can depend on whether the company is a private or a public company; in a private company it can be put in an indenture that the Permitted Holders must own 35% of the company, but in case of a public company, the indenture may allow this number to go all the way down to 0, but restrict people other than Permitted Holders to own more than 35% of the company.
• Additional Debt: every covenant allows the issue to refinance its debt but will disallow from increasing the average life of the debt, or to refinance subordinate debt with senior debt.
• Liens: This is a very important covenant for a Senior note, to make sure that the  notes remain as senior as possible. For a Subordinated note, there’s usually have an “anti-layering protection” to make sure that there’s no additional lien granting other any liens to secure any other subordinated debt. Senior notes often disallow additional liens except certain exceptions, unless an equal lien is extended for the benefit of the bondholders.

Bank Loan Covenants

Usually bank loan covenants are more restrictive with a number of additional (incl.  affirmative) covenants, but are also relatively easily amended, given meaningful presence of lead/agent banks (most credit agreement terms can be amended with a simple majority, and is easy to do in an easy lending environment, esp. given appropriate pricing/consent fees).

• Mandatory prepayments: amortization / excess cash flow sweep
• Maintenance covenants: usually have a 20% haircut compared to issuer’s projections to provide a reasonable cushion. Sponsor deals typically have very loose covenants to allow for maximum flexibility.
• Covenant step-downs: very beneficial to bondholders

Trading Factors

• Liquidity factors
  • issue size < $200m
  • total bond issue outstanding < $750m
  • only one market maker? only one underwriter (and is that a major underwriter)?
  • listed on credit swap index (CDX)?
  • little volume on TRACE?
• Volatility of price history
• Spread
  • relative to history and leverage
  • relative to the industry and the overall HY index
• Equity cushion / EV coverage: this is an indication of asset coverage. Thinning equity cushion would imply that the bonds will begin to require equity-like returns.
• Comparison to yield of the bank loan.
• Duration
• Compare to the Equity prices and how senior instruments such as loans are trading.

Credit Models for Assessing Firm Risk

These models supposedly provide ex-ante direct measure of default risk. There are two types of these models: (a) fundamentals-based, and (b) market-based. The most widely used quantitative credit model is Moody’s KMV EDF model, which Merton model, which in turn is based on work of Black-Scholes. The three main drivers of default are (a) asset value, (b) asset volatility and (c) leverage.

Managing High Yield Assets

Managing high yield assets can be divided into two major components–(a) portfolio optimization (which entails looking at the market conditions, and tools such as checklists, decision-making and weighting distribution model), and (b) risk controls (which include procedure to identify risk factors in credit, market, liquidity and portfolio).  While it may be difficult to construct an entire portfolio of 100-150 credits with the right combination, one should look to have at least the top-20 credits with the perfect combination of (a) good credit metrics, (b) good industry fundamentals, and (c) good favorable technical market factors.

It is very important to have the right process to invest in a bond. It consists of –

1. proper deal structure (sponsors, special characteristics, covenants): weak sponsors and underwriters are associated with riskier transactions. 144A for life transactions have usually less due diligence. Some sponsors are known for taking too high dividends and some take advantage of a dispersed creditor base to utilize “divide and conquer” techniques such as combined tender and consent offers.
2. macro industry outlook: capital intensiveness, competitiveness, profitability, growth rate etc.
3. credit fundamentals of the issuer (leverage, coverage): very important to understand the management (has it impaired bondholders before?) and “cash leakage”.
4. technical market conditions (liquidity, inflow/outflow, trading volume). One of the risk measures should be the amount of bond brought in by one underwriter.
5. price (spread)

It is extremely difficult to outperform an index in both rising and falling markets because it takes completely different type of credits and strategy to do so. The secondary market in the HY market has never offered enough liquidity to switch billions of $s from bull credits to bear credits.

Distressed Investing

Bankruptcy courts are courts of equity and not courts of law, which means that judges have broad equitable powers and do not need to adhere to strict interpretation of the law. This means that everything is negotiable and depends heavily on the judge. Due to bankruptcy laws, uncertainty is a given. For example, to protect the large creditors , 2/3rd of the claim amounts is required to approve the plan, but to protect the small creditors, it also requires approval from 51% of the claim votes–this is to foster compromise and consensus. Note that claimants are the impaired creditors (unimpaired creditors do not get a say).

The U.S. bankruptcy is essentially a “second chance” (Georgia was a debtors’ colony ala Australia) and there have been significant revisions to the bankruptcy law since it was put in the Constitution (in 1980s, it made it harder to void labor contracts, later selling of the NOLs was made unconstitutional, and 2005 landlord and vendor rights were improved, along with the time a company can stay in bankruptcy). During bankruptcy, all litigation is stayed. Overall, prepackaged and prearranged bankruptcies are preferred as they involve much less uncertainty by the vendors etc and can help avoid greater value destruction. Chapter 11 is preferred, but in case of Chapter 7, judge can hold auction of assets under the section 363 of the code, and the sales are called 363 sales (usually involve a “stalking horse” bidder that provides the initial price).

Distressed investors want to be a part of the fulcrum security.