Worry Discount Overcompensates Investors For Corporate Credit Risk

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 who is an executive of a major institutional investment firm in the corporate credit sphere described recently how the average market price for healthy corporate senior secured loans (i.e. “leveraged loans”) had currently dropped to 92 cents on the dollar.

These are the sort of assets held by senior loan closed-end funds as well as by collateralized loan obligations (“CLOs”), of the sort 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 that the market anticipates 8% losses in corporate credit portfolios. This would make sense if we expect the recession or whatever lies ahead to be a whole lot worse than the “Great Recession” of 2008/2009, which was called that because it was by far the worst economic downturn since the “Great Depression” of the 1930s.

But for those who expect just a garden variety recession, or even a “mild recession” as is being predicted by many economists I read, discounts of 8% on currently healthy corporate loans suggest real opportunities and bargain prices for more sophisticated credit investors.

In order to actually lose 8% on a corporate loan portfolio, you would need to have defaults of 20% or more. That’s because senior corporate loans are secured by collateral, with a historical average recovery rate of 70% (i.e. a 30% average loss on the defaulted loan). At that historical loss and recovery rate, a 20% default rate with 30% losses on defaulted loans, would result in 20% times 30%, or a 6% overall portfolio loss.

Even if you take a more pessimistic view of future recoveries on defaulted loans, as some analysts are doing currently, and assume only 60% recoveries (i.e. 40% losses), that would mean a 20% default rate would result in portfolio losses of 8%. (i.e. 20% times 40% = 8%). Hence, to justify an 8% price discount, you’d have to be anticipating a 20% default rate.

The default rate in the 2008/2009 recession got as high as about 10%. That meant, with a 70% recovery rate back then (i.e. 30% loss rate) that the overall portfolio loss for a typical corporate loan portfolio was 10% times 30%, or 3%. (Putting that in perspective, a 3% hit would have reduced substantially a single year’s income from a loan portfolio, but it wouldn’t even have dug into principal.)

That means the corporate credit market is pricing in losses over twice as high as those suffered in the “Great Recession.” This over-estimation of potential loss has happened before, including in the 2008/2009 period itself, when healthy corporate loans and bonds were often selling in the 60-70 cents-on-the-dollar range (or even lower). 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 healthy, performing borrowers (i.e. almost all of them) into loans and bonds of other healthy borrowers at incredibly low, bargain prices. Then when the borrowers repaid at par a few years later, the investors (who had been collecting inflated coupons to begin with, given the discounted prices at which they bought the debt) would also collect big capital gains equal to the difference between the 100 cents on the dollar they collect at maturity, and the 60 or 70 cents they originally paid to buy the debt.

With corporate debt selling at big discounts, and spreads on that debt wider to begin with by a couple hundred basis points than they were a year ago, many credit investors see this as a very attractive opportunity.

Credit Investing: “Equity Returns Without Equity Risks”

Many readers know that one of my favorite themes is how to earn average annualized “equity returns” of 9-10% or so without the volatility and unpredictability of owning real equity. Part of what makes this possible is the misunderstanding by so many investors of what they are really “betting on” when they buy corporate credit versus corporate equity. For more on this topic, read this and also this.

Bottom line: Whenever you buy a company’s stock, you are not only betting that the company will thrive, grow 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, anyone who buys stock in a company is also taking on all the risks of the investors who hold that same company’s debt (loans and bonds).

Ironically, many of the equity owners of smaller and mid-cap companies swear they’d never buy “junk” bonds, but by owning the equity of the same cohort of companies that issue so-called “junk” bonds, they are taking even more risk than the holders of those bonds, who outrank them and will get paid first if the company goes bust, before the equity owners collect a nickel.

This has created and continues to offer investors a lot of opportunities in the credit markets, whether the specific funds listed above, or business development companies like Barings (BDC) that I’ve written about recently, as well as other credit funds included in our model portfolios and other lists of investment candidates. (Here are some additional ideas along these lines as well.)

Thanks for your interest and I look forward to your comments and questions.