Third Avenue on Sovereign Debt Debacle

In previous posts in the past, we've highlighted the fantastic commentary from Third Avenue's Focused Credit Fund. The fund commentary for the most recent quarter is again out, and I'd thought I'd highlight the discussion on sovereign risk. You can read the entire commentary here: Third Avenue 3Q 2011 Shareholder Reports. Enjoy!

Sovereigns, Corporate and Bankruptcy

Our investors have been asking us about sovereign debt ever since the question of European solvency emerged in 2010. The prospect of truly high-yield debt, paying in some cases north of 20%, emerging from the European Union instead of the more traditional confines of the emerging markets, has some bond buyers salivating and others just plain scared. Government debt is supposed to be the safe stuff, after all. A compelling case can be made for that, unless things go wrong. At the moment, the potential for things to go wrong for sovereigns is very high. They have bonds coming due and need access to the capital markets in order to refinance them.

Sovereigns have three things going for them, from an investor’s point of view:

• They can print their own money, so a sovereign borrower that issues debt in its own currency can avoid default. However, investors risk serious currency devaluation. For example, the Brazil 10-year bond issued in U.S. dollars yields 3.5%, while the equivalent maturity bond issued in the local currency (the Brazilian real) yields 8.5%. This difference in required return reflects investors’ uncertainty or concerns about the possible devaluation of the real. In addition, if a significant amount of a country's debt is issued in a foreign currency or the country has given up control of its own money supply (as with the Eurozone countries) they can find themselves at the mercy of the capital markets and face an increased risk of default.

• A government can raise taxes on their citizens and corporations or raise other fees, in order to cover its obligations, though political considerations can temper this impulse.

• There are international agencies, banks and financial arrangements that can come to the aid of a failing sovereign borrower, while most corporate borrowers have to stand or fall on their own.

Corporate borrowers cannot print money and they cannot raise prices and just expect to keep their customers. A country in worse financial shape can use its central bank to kick the can down the road. Corporations also cannot appeal to the International Monetary Fund or the World Bank for a rescue. With very few exceptions, an overly indebted corporation that is unable to meet its obligations will be allowed to fail, no matter how important its managers and shareholders think it is.

While that might make it sound like sovereign debt has a certain safety to it that corporate debt does not, this is largely illusory from the point of view of a debt holder. When you own sovereign debt, you have very little leverage with your borrowers. Because a sovereign’s debt is backed by the full faith and credit of the sovereign entity, once faith is gone liquidity evaporates and a sovereign’s ability to borrow ceases. The liquidity crisis can create a solvency crisis. Conversely, if a corporation experiences a liquidity crisis it does not necessarily create a solvency crisis, as its assets may be used as collateral to raise capital at some point in the capital structure. If all else fails, you have the court system to seize assets.

From a creditor’s perspective, the weaknesses of holding sovereign debt are directly attributable to the lack of protections afforded by a bankruptcy code.

• A sovereign entity can delay restructuring its debt indefinitely.

• A country’s land, assets or people cannot be repossesed by lenders.

• A country cannot be wound down or reorganized into something else.

• A country’s leaders are beholden to constituencies other than bond holders.

• Ultimately, a country’s leaders cannot be forced by creditors to make decisions that they do not want to make.

While we have been discussing this in terms of a country’s debt, sovereigns are really a broader category that includes municipal debt and debt issued by Native American tribes to fund casinos operating under the Indian Gaming Regulatory Act. Municipal debt can be broken down into two categories – general obligation bonds and revenue bonds. General obligation bonds act like sovereign debt, as they are backed by the full faith and credit of the state or municipality issuing them. Revenue bonds, on the other hand, are more like corporate debt, as they are backed by assets or a revenue stream (such as a bridge or toll road) and rates can be raised or, theoretically, assets seized in order to pay bondholders.

In recent history, we have seen countries choose default and receive scant economic punishment for doing so. Russia defaulted in the late 1990s and saw its cost of borrowing skyrocket. But a few years later, conditions normalized. In 2001, Argentina, which had linked its currency to the U.S. dollar and had, thus, given up the ability to print money to cover its debts, chose default over an austerity and divestiture programs pushed by the International Monetary Fund. Argentina’s bondholders lost 70% on average. It has been said that buying Argentina’s bonds is like getting remarried (the triumph of hope over experience). Only in Argentina’s case, it is like remarrying the same person three times and expecting a different outcome. Unlike private companies, countries do not dissolve just because they default. They live to borrow another day.

One of the unifying characteristics of all of these sovereign bonds is that the interests of debt holders are often not paramount in the event of insolvency. Governments are accountable to (or fear) their people first and foremost. Politicians are sometimes even rewarded for not making unpopular concessions to bondholders. As mayor of Cleveland in the 1970s, Dennis Kucinich allowed his city to default, rather than agreeing to sell its public utility. That decision made him wildly popular with his constituents and is the main reason he is a congressman thirty years later. It may not be right from the creditor’s perspective, but it is reality.

The Focused Credit Fund owns one municipal bond issue, backed by the revenue of 9,000 parking spaces around Yankee Stadium and one bond tied to a Native American owned casino.

The advantages of holding corporate debt become clear when a company faces the threat of a potential restructuring:

• Managers have strong incentive to pay lenders because they stand to lose their jobs and equity if they do not.

• Corporations can sell some of their assets or divest businesses in order to pay obligations.

• Corporations can be wound down and their assets sold to pay creditors.

• Corporations can be reorganized into new businesses, with the new equity going to its creditors.

• Corporations in financial trouble can be purchased by a more financially secure company.

• There are clear laws, procedures and precendents that govern the U.S. corporate bankruptcy process, whereas anything goes in a sovereign default.

• The U.S. bankruptcy code sets forth a clear priority for claims that assures that debt holders are treated fairly in order of their rank and seniority in the capital structure.

• There is a limited time of exclusivity for the debtor in bankruptcy before debtholders can gain control.

The corporate borrowers that we are discussing here are either governed by U.S. bankruptcy law or something similar. In countries with unfriendly or uncertain bankruptcy laws, and in the area of sovereign debt, the interests of creditors are not as protected. The absolute priority for claims provides a structure that borrowers and lenders can use to work through solvency and liquidity issues. For example, a corporation can offer to exchange existing debt for more senior paper in order to extend maturities and reduce short-term debt obligations. Since there is no similar absolute priority of claims with sovereign debt (witness the recent debt ceiling debate about which U.S. creditors would be paid first in the event of default), this type of exchange is difficult, if not impossible.

When a sovereign issuer faces a solvency crisis, the willingness of the government to pay its creditors becomes the key issue. A corporation almost always wants to pay, in order for management to save itself. It will sell prize assets to do so. A country will not. Could you imagine the U.S. government selling Yellowstone National Park to China and then letting a foreign government run it for profit? The decision by Greece’s government to divest some of its assets in order to pay bondholders is at the root of much civil unrest there. Around the world, we have seen leaders elected on a platform of not allowing foreign bondholders to take from the people. Lenders to corporations are not so often treated as pariah outsiders. When a company is in the zone of insolvency, its Board of Directors becomes accountable to its lenders and can be compelled by a court to act in their creditors’ interests.

Setting outright invasions aside, there is no merger and acquisition market for countries. In the corporate world, resource conversions can serve both debt and equity holders well. Germany cannot buy Italy and make it more German. A corporate restructuring or resource conversion has the potential to deliver equity-like returns for creditors, because assets that the corporation might have bought at a discount can later be sold at a premium. Sovereigns cannot offer such returns, because they cannot be restructured.

Ultimately, the buyer of sovereign debt is making the leap of faith that the borrower will repay, even when times are tough and even if it is not politically expedient to do so. The owner of corporate debt has to trust their borrower as well, but that trust can be enforced through the lender’s legal claims on the borrower’s assets. We feel safer in that more tangible world of debt investing.

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Thoughts from Third Avenue's Special Situations Fund

At Distressed Debt Investing we have discussed (in detail) Third Avenue Credit Focused Fund, a group I very much respect. What a lot of people don't know though, is that Third Avenue also has a special situations fund (fund name = Third Avenue Special Situations Fund) run by Michael Fineman. While I will not post the entire letter, I will grab snippets which I think are particularly insightful.

On Chrysler Financial (a favorite among many distressed funds)

"During the quarter we greatly expanded our interest in a private company (“FinCo”) that indirectly owns 100% of Chrysler Financial. At our purchase price we believe we are buying a well-seasoned portfolio of automotive loans and leases at roughly two-thirds of run-off value. Importantly, the underlying portfolio has a very short duration, as the overwhelming majority of the book is expected to be liquidated in approximately two years.

By way of background, before the April 2009 bankruptcy filing of automotive manufacturer Chrysler LLC (“CarCo”), FinCo was the captive finance provider for CarCo. During the peak of the crisis and rumors of bankruptcy, FinCo equity was marked in the low to mid 20s. However, since CarCo’s bankruptcy and emergence in later summer 2009, Ally/GMAC has assumed FinCo’s previous duties as the primary provider of retail, lease, and wholesale financing for CarCo-manufactured vehicles. As such, FinCo is currently in run-off, with assets turning into cash on an accelerated basis.

Given the seasoning of FinCo’s book, consumer/wholesale default stabilization, and a remarkable turnaround in used vehicle prices, we are confident FinCo’s reported balance sheet is conservatively marked and we have a large margin of safety when you consider the significance of our purchase price discount. The primary uncertainty associated with this investment is the timing of when capital will be returned, which may be dictated by how the managing partner of this private equity interest seeks to re-deploy these funds. Given what we perceive to be an acceptable alignment of interests, we view the downside to this investment to be a mediocre IRR and the upside to be a holding period return in excess of 60% from current levels after already experiencing material appreciation."

Another distressed debt special: GMAC Preferred's

Ally 7% Cumulative Perpetual Preferred Stock (“PS”) pricing was volatile during the quarter, and we added to our position (while still leaving substantial room to buy more) as prices have fallen. Regular readers of our letters will recall in 2008 and 2009 that we successfully invested in the unsecured bonds of GMAC on multiple occasions. Now, with the prospect of an Ally Financial IPO over a one-to-two year horizon we believe our preferred shares are well situated in the capital stack: Preferred share pricing results in a 9%+ current yield to us, with upside on an early par takeout if Ally management and the majority common shareholder (United States Treasury) look to facilitate a smooth S-1 filing by redeeming us and removing our common dividend blocker.

Of course, we do not hold a contractual right to early redemption, and it is entirely possible Ally could execute a successful IPO with our preferred share common dividend restriction in place. However, even in this downside case we believe we are likely to be credit-enhanced in advance of an IPO when the Treasury converts some or all of its $11.4 billion of mandatorily convertible preferred stock (currently pari passu with our $2.7 billion of PS) into common stock to thicken the common layer and increase Tier 1 common levels to a more acceptable range.

And on their general outlook:

The Fund remains focused on both distressed performing credit and debt-for-equity investments. Since the start of the year we’ve been telling investors that the middle market (companies with total debt less than $3 billion, but less than $1 billion the real sweet spot) is the most attractive environment for debt-for-equity investments. These companies have typically relied on leveraged loans provided by collateralized loan obligations (CLOs) and regional banks for their financing needs, rather than the high yield markets, which serves larger companies who issue larger amounts of debt. The continued shortage of capital available from CLOs and regional banks has made it difficult for middle market companies to refinance or extend the maturities of their existing debt, even as their larger competitors go to the high yield markets to take advantage of still low interest rates. When so many leveraged companies are facing real hard maturities in the near term it creates opportunities for distressed investors.

The second quarter saw increased volatility in both the credit and equity markets as investors absorbed news of the Eurozone’s sovereign debt problems and China’s attempts to manage and slow its economic growth. Third Avenue’s “Safe and Cheap” approach to investing serves us well in times like these by providing strong risk adjusted returns. We analyze many companies and attempt to determine the optimum security within the capital structure and at the appropriate pricing level that limits our downside. Such volatility as the markets experienced recently has helped to create those buying opportunities for the fund.

We continue to size our positions based on our risk analysis of each issue which has provided for several high-conviction, highly concentrated positions that we believe have limited downside. Fund management has also implemented certain inexpensive hedges to hopefully mitigate the tail risk associated with specific companies as well as macro hedges. Finally, we have initiated and increased certain positions that have hard scheduled events and therefore are capable of generating strong returns no matter how the market behaves.

The macro backdrop supporting this middle market thesis remains the same as we had written about in our First Quarter 2010 letter; but recent events noted below seem to further support our thesis:

• Sovereign default risk has expanded from one EU country to several, not to mention austerity measures being taken by many other countries;
• The FDIC list of problem banks has grown from 702 to 775;
• Unemployment rates continue to remain just under 10%;
• Some $1 trillion dollars of maturities come due over 5 years, albeit back end loaded; and
• Many balance sheets remain highly leveraged as earnings are first fighting to return to the levels of 2005-2007; let alone grow into those balance sheets.

We could not agree more. The Unwinding of the CLO bubble, is going to make it a very interesting couple of years for distressed debt investors.

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Distressed Debt Fund Commentary

A few months ago, we took some time out to profile Third Avenue's Focused Credit Fund. We were particularly impressed with some of the commentary coming out of the manager's letter.

As a side note, if you work at Third Avenue, can you please shoot me an email (hunter [at] distressed-debt-investing [dot] com). Have a question.

We thought we would check in and see if Third Avenue's managers had released more commentary, and we were please what we found their 2010 First Quarter Report (yes - I know this came out at the end of January...don't shoot the messenger).

What I found interesting reading through the various manager's commentaries were the fact that the value funds had invested in a few of the distressed situations which they worked with the credit team to identify. For example, Curtis Jensen in the small cap value fund notes:

Energy XXI Senior Notes represent the Fund’s second debt investment in a U.S. Gulf of Mexico-focused oil and gas producer. Securities valuations of Gulf of Mexico (“GOM”) energy companies like Energy XXI had been decimated in late 2008 following the disruption brought on by Hurricanes Ike and Gustav. The dramatic collapse in commodity prices during that period further pressured the industry’s operating results and, in many cases, led to dramatic accounting-based asset impairments. Energy XXI’s production levels, for example, fell more than 26% in the first quarter following the hurricanes and GAAP accounting resulted in a $580 million impairment of the company’s oil and gas reserves. The opportunity in Energy XXI Notes surfaced at the end of last year while the company was in the midst of a debt exchange offer designed to address a capital structure ill prepared for these sorts of adverse developments. We believed that the company’s “troubles” – both financial and operational – were temporary and fixable, that our capital, as creditors, was well protected and the investment had a number of ways to win:

• the proposed exchange offer and a coincident private financing included a credit-enhancing common stock offer that also extended the company’s debt maturities;

• production that had been interrupted because of the hurricanes would return, in time, along with additional production pending completion on more recent projects, bolstering both cash flow and reserves; the company was due to collect the proceeds of a substantial insurance settlement, further enhancing corporate liquidity;

• our multi-pronged valuation work, which relied on asset-based production and cash flow metrics, suggested our downside was well protected (i.e., the probability of a loss of capital seemed remote) while the Notes, trading at a price of around 81% of face value at the time of acquisition, provided an equitylike return of more than 17% and a current yield of approximately 12%;

• creditors like the Fund could get further comfort from the relatively strong covenants within the terms of the Notes and those in the company’s bank credit facility;

• While unnecessary for a successful investment, the company’s exposure to a potentially large exploratory success would further enhance overall corporate value;

• finally, other facts, taken together, strongly suggested to us that management was intent on improving the balance sheet. These clues included i) the company’s most recent proxy statement that requested a sizable expansion of the company’s authorized share capital, signaling a potential future equity raise; ii) new “change of control” language within the new notes indenture that seemed to contemplate the impact of an expanded equity base; iii) the fact that the company itself had repurchased $126 million face amount of Notes at a cost of $94 million1, suggesting a proactive approach toward enhancing the corporation’s financial flexibility; and iv) comments on the company’s recent conference calls and presentations committing to “debt reduction” and “further strengthening of the balance sheet.”

While subsequent events at the company largely support our thesis (a thesis developed with our colleagues on the Third Avenue credit team), the investment continues to face a number of hard-to-handicap risks, chief among them: i) operational risk (hurricane season starts in June!); ii) political risk (uncertainty related to how the Obama administration might change the industry tax regime or rules on access to reserves); and iii) deal risk (the possibility that significant new leverage is introduced as the result of either a debt-financed acquisition or a takeover of the company by a highly leveraged acquirer).

Readers active in the distressed debt market will know Energy XII was a hot topic. And given where those notes are trading right now, the investment looked like it paid off.

Let's move on to the credit team's commentary. And as discussed in previous posts here: Lots of capital is flowing to the distressed space: The Credit Fund's assets grew from $280M to $545M at the end the quarter. Their performance slightly lagged the Barclays HY Index and CSFB Leveraged Loan Index due to a position in Blockbuster's Senior Secured Notes (a hotly discussed topic on the Distressed Debt Investors Club site) and high cash balances.

On the market's returns in the quarter:

Market returns were led by CCC-rated issues which returned nearly two times the index return in the most recent quarter. This included a number of higher-risk Finance company bonds. The Finance sector had the highest return in the high-yield index for the quarter, with a return of 9.25%. For many of the Finance sector bonds that performed well, Fund Management determined there was not adequate information or transparency available on specific companies to be able to obtain a high enough conviction level that there would be minimal downside risk. These bonds included AIG, ILFC, Rescap, Aiful, Takefuji, as well as several hybrid/perpetual preferre stocks of U.S. and European banks.

On the market pullback we discussed in February:

We view this market pullback, which has continued into February, as constructive and a good opportunity for us as investors. As we have said in the past, “Trees don’t grow to the sky” and this is especially true in the credit markets. It seems that investors are finally paying attention to thefundamentals and capital structure of specific companies since the rally in the credit markets began in March 2009. In general, during this rally, the riskiest securities benefitted the most. Returns on CCC-rated high-yield bonds exceeded 100% in 2009, despite the fact that many of these companies have over-leveraged balance sheets and their cash flows from operations have declined meaningfully.

Risk appetites for these types of companies appear to be diminishing. Companies that report disappointing earnings or have uncertain outlooks have seen their security prices decline recently. This is the type of market we favor and believe we can excel in – it is what we call a “Credit Picker’s” market. We believe that investors should be invested with a manager that focuses on credit selection and carefully measures the upside potential versus downside risk of each security, as opposed to investing with a manager that just buys the riskiest securities in hopes that they will increase.

Apparently they were also caught off guard on how fast the market snapped back in March. I tend to agree - that this is the kind of market where the wheat is separated from the chaff. Especially given how volatile the market feels when you are trading it (i.e. in the morning you will not be able to buy a bond, bad news comes out, and then you would not be able to sell the bond in the afternoon). Credit selection is so important in a market like this.

From reading their commentary, they believe that returns for the next few years should be moderately positive but investors should not look to 2009 as a barometer for returns going forward. And as noted in previous posts on this blog, the refinancing wall of 2012-2014, despite being worked down in past months, still is a monstrous number to the tune of $600-$700B.

The manager, Jeff Gary, then goes on to talk about some individual investments. This is a very good read and I suggest you go read it. The one I will post here is again on Energy XXI to give the reader more perspective on the investment:

Energy XXI (“EXXI”) is an independent oil and natural gas exploration and production company with operations focused in the U.S. Gulf Coast and the Gulf of Mexico. (This credit is also discussed in the Third Avenue Small-Cap Value Fund shareholders’ letter, which you can refer to for additional information.)

Due to hurricanes which disrupted production in the Gulf of Mexico and the collapse in commodity prices, EXXI ran into liquidity issues. During the fourth quarter, EXXI attempted to do a debt exchange whereby it would exchange approximately 50% of its $625 million 10% Senior Notes for new 16% second lien secured notes at a price of 80% of par. Additionally, EXXI planned to retire the $125 million in 10% bonds the company had purchased to reduce its overall debt load.

Based on our proprietary research, we determined that EXXI’s oil reserves more than covered the value of its debt at par and the 10% notes were trading in the low 80 dollar price range. When we discussed the rationale for the debt exchange with management, they said there were two key reasons. First, it would reduce slightly its overall debt. Second, they wanted to modify the “Change of Control” provision in the new 16% second lien notes so it would be different than the 10% Notes. A “Change of Control” provision is standard in high-yield bonds and provides that if a company is bought out by another company, then the bondholders can force the company to repurchase their bonds at a price of 101% of par.

EXXI wanted the flexibility to be able to issue more than 50% of their outstanding common stock in a new acquisition deal. This would have triggered a “Change of Control” in the 10% notes. This led us to conclude that management wanted to do an acquisition funded with almost all equity, in order to substantially reduce its ratio of debt to equity. If this happened it would positively impact the bonds. We purchased the 10% senior notes and agreed to the debt exchange. Following the debt exchange, the combination of the new notes traded at a higher price than our cost basis.

In November 2009, EXXI announced that it was purchasing interests in oil properties from Mitsui & Co. for $283 million. These are interests in oil fields that EXXI already owns and operates. They were able to negotiate a favorable purchase price and will incur almost no additional operating costs. EXXI then completed an equity and convertible bond offering to fund the entire transaction.

EXXI owns interests in two deepwater exploration fields being drilled and operated by McMoran. Our analysis attributed no value to these fields, since there was no discovery yet but they were drilling the wells and had incurred costs. In January, EXXI and McMoran announced favorable findings for one of these wells. The stock now has a market capitalization of $1 billion and the 10% and 16% notes we own now trade at par and 115% of par, respectively.

Spectacular analysis.

And finally, in a footnote, there is commentary on the fund's top 10 largest issuers as of January 31st:

The following is a list of Third Avenue Focused Credit Fund’s 10 largest issuers and the percentage of the total net assets each represented, as of January 31, 2010: Swift Transportation, 4.2%; Energy XXI Gulf Coast, Inc., 3.8%; CIT Group, Inc., 3.0%; TXU Corp., 2.9%; Lyondell Chemical Co., 2.9%; Pinnacle Foods Finance LLC, 2.8%; First Data Corp., 2.7%; FMG Finance Ltd., 2.7%; Georgia Gulf Corp., 2.5%; and Culligan International Co., 2.3%.

I know most of these names well and will try to write up a snippet about each in the coming weeks. I will note, that a lot of these names have run substantially since Jan 31st.

Overall, very strong distressed debt commentary out of the Third Avenue's Credit Team.

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