What in God's Name is Going on in the Muni Market?

One of the reasons I have always enjoyed being involved in the high yield and distressed debt markets is the ability to really dig through things that have been completely beaten down and no one wants to touch.

In early 2008, there were a series of event that lead to a number of well regarded municipal issuers having to pay 10-20% on their auction rate securities. We bought as much of the vanilla issuers as we could- after it was announced that Warren Buffett was doing the same thing, the trade stopped working as municipalities got smart and started terming out their debt.

Well today, a friend emailed me, and told me to look at the charts on a number of levered muni closed end funds. Have you see these charts? Let's pull up the old 4x1 Bloomberg Graph, comparing with ETF and three different closed end muni funds:

For reference:

• MUS: BlackRock MuniHoldings Quality Fund
• PML: PIMCO Municipal Income Fund II
• FMN: Federated Premier Municipal Income Fund
• HYD: Market Vectors High Yield Municipal Index ETF

I thought to myself - it has to be the move in the treasury right? So I added the 30 year treasury bond to the graph:

As you can see, the sell off has been significantly more dramatic in the closed end and muni ETFs relative to the long bond. So what is going on?

I do not regularly invest in this market unless there is at least a little blood in the streets - little did I know there is a lot of blood in the streets. The muni markets was hit with a perfect storm of negativity over the past few weeks:

1. A huge supply calendar: JP Morgan notes that next week could be the record for muni supply coming to market IN U.S. HISTORY (my emphasis added)
2. Republicans win election means state budgets get less support from the federal government which means increasing stress on ability of municipalities to pay (and certain muni provision as part of President Obama's stimulus bill that need to be re-upped)
3. Everyone and their mother front-running the Fed and the subsequent unwind (compounded by the unwind of the long end of the Treasury curve as well)
4. Leverage, leverage, leverage. Most of these closed end muni ETFs are levered one way or the other. Further, and I really cannot believe they still exist after the debacle that was 2008, municipal arbitrage hedge funds probably were probably crushed with the recent moves in the curve. Borrow short to invest long? Even with hedging via swaps and swaptions, imbalances between the muni curve and treasury curve arise and when you are 20x levered disaster can strike.
5. Concerns over BABs expiration: If you didn't know, the Build America Bonds program expire on December 31st. Issuers want to sell as much paper as possible to avoid the chance the interest credit gets removed - again more supply on the market.
6. Muni mutual fund flow is nill at best: According to AMG, approximately $45M has been put to work in the last two weeks in municipal bond funds. The average weekly inflow this year is over $650M.
7. The economy and general risk concerns (i.e. Allied Irish Bank, Asia raising rates, etc)

As would be expected in such an environment, the credit curve for tax exempt bonds is steeping - and FAST. We are talking unheard of moves.

But what is an investor to do in this sort of environment? I say average down. Supply is going to continue to stay high until clarity on BABs/Stimulus Provision (specifically the AMT provision - muni's issued in 2009/2010 are exempt from property and casualty insurers which are large buyers in this space) and demand will be tepid. I personally will be dipping my toes in some of the closed end New York muni funds (PNI, EVY, etc) sporting 6-7% yields (nearly 10% taxable equivalent). Hell - I live in New York - and if this ship is going down, I'm taking my tax exempt bonds with me.

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13Fs and Post Reorg Equities

One of the my favorite times each quarter is the 45th day after quarter end when hedge funds report their holdings in stocks. My good friend Jay at Market Folly is far and away the best coverage of 13Fs out there and I strongly you suggest you frequently check his site for analysis of some of the best hedge funds in the world.

As a distressed/event-driven investor, I allocate a substantial amount of time to post reorg equities. Many distressed debt funds have a mandate to purchase companies emerging from bankruptcy or who have recently emerged from bankruptcy. Many funds stretch the "recently" to five, six, or even seven years so you will see many distressed funds in names that many people forget even went through the bankruptcy process.

With that said, I also like to look at companies which have recently emerged from Chapter 11 and have a substantial float to get a sense of what event driven and distressed debt funds are doing in these post reorg securities. Let's take a look at a company which recently emerged: Smurfit Stone (SSCC respectively).

Before we begin though, one caveat. Many distressed debt funds will play a reorg prior to a emergence, and then wait until the company is listed and possibly picked up by an index to sell the security into the index buying strength. As with all 13Fs, these filings are just a way to find more ideas and get a sense of what funds are doing out there in post reorg land.

On June 30th, SSCC announced its emergence from bankruptcy. Let's take a peak at their holders list (I've decided to include only the top 30 holders here):

As you can see, this list of 30 funds is a pretty diverse group. Just looking at the top 15 holders (top image), here are the funds I see:

• Royal Capital Management: A well regarded long/short hedge fund that also has played in Lear.
• Apollo Management: Self-explanatory - one of the best.
• Wayzata Investment Partners: All over the distressed scene playing in recent bankruptcy emergences like Neff, Rath Gibson, and Merisant
• Columbus Hill Capital: Started by a former Appaloosa partner (they are also located in Short Hills, NJ), their 13F has names like Dana, MGIC, PMI, Lear as well as some well known large caps like BAC and IP.
• Elm Ridge: Started by Ron Gutfleish who spent time at Omega and GSAM, Barron's wrote in April 2004: "Gutfleish and his posse run their hedge-fund operation from an ultramodern New York office building on Third Avenue. They pride themselves on their ability to stir the pot of controversy. In the almost four years it has been in operation, Elm Ridge has won a reputation for being able to make money in all sorts of markets by aggressive analysis and bare-knuckle trading."
• Brigade Capital: One of the newer members of the distressed pack but also highly highly regarded. Very smart group of portfolio managers and analysts there that play up and down the capital structure and strategies.
• JGD Management i.e. York Capital: Blue chip and as best as they come.
• P Schoenfeld Asset Management: Check their website. Great stuff.
• Litespeed Management: Well regarded event-driven fun run by Jamie Zimmerman, playing in merger arb, distressed debt, and special situations.

Next quarter, after the 12/31/2010 13F filings are in we will re-visit this post re-reorg equity to see who stayed in versus who flipped the security after it emerged from bankruptcy.

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Two Great Articles from Simoleon Sense

My good friend Miguel Barbosa has put up some absolutely amazing content at his blog Simoleon Sense.

The first is a no-holds barred, extensive interview with Alice Schroeder, author of The Snowball, THE (my emphasis) biography you have to read on Warren Buffett. In this interview, Alice releases some never-before talked about characteristics of WEB's investing style. It is an absolutely fascinating read.

Simoleon Sense Full Interview With Warren Buffett's Biographer Alice, Schroeder

The second document is a set of notes from the "Invest for Kids 2010 Conference." A fantastic charity, invest for kids features speakers including Bill Ackman, Josh Freidman, and Larry Robbins (among others). Enjoy!

Invest for Kids 2010 Conference Notes

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Greenlight Capital: 3rd Quarter 2010 Letter

Greenlight Capital released their 3rd Quarter 2010 letter (courtesy of Dealbreaker) which you can see here: Greenlight Capital's 3rd Quarter 2010 Letter.

Outside of the fantastic commentary on the eventual failure of QE2 to actually accomplish anything substantial (a position I strongly agree with), one of the most interesting things I took away from the letter was Greenlight's activity in distressed debt.

In the letter, Greenlight points out that they purchased the debt and equity of ATP Oil & Gas, a recent favorite of many members of the distressed debt community. As an example, in June, two members of the Distressed Debt Investors Club both pitched the ATP debt as longs with sizable return potential. How have those bonds done since June? Pretty well:

What happened here. Let me see if I can give you a quick run-down of the situation:

• Deep water drilling moratorium enacted in the Gulf due to the BP spill - a 6 month halt on drilling could cost lots of money for ATP as 60% of their reserves are located in deepwater GOM. That combined with a heavy capex program - people begin to worry about the future cash flow potential of this company. People even begin to mention a possibly bankruptcy due to a cash crunch. Sell side starts downgrading en masse (i.e. time to start looking at it as a long)
• Bonds continue to weaken. On the 8th of June, bonds are down 4-6 points in thin trading. Reason: The purported second leak that didn't actually exist. A downgrade to CCC+ did not help either.
• Bonds start moving higher as rumors that the drilling moratorium on deep water drilling could end sooner. Stock moving 10-15% a day up also seemed to help.
• Louisiana judge lifts ban - bonds shoot up - felt like a short squeeze really as bonds felt heavy post.
• ATP place a new $150M term loan (with an option to extend to $500M). Market begins to start pricing ATP as a going concern versus a liquidation (despite the possible increased priming)
• Bonds weaken as representatives from the House begin discussing the $75M liability cap (i.e. insurance would be prohibitively expensive for someone like ATP) and a new moratorium is put into place.
• Bonds move up on no volume/news until ATP releases disappointing 2Q numbers - then bonds move down on substantial volume
• Beginning of September there was rumors on another rig explosion: One bold trader made a 75-80 market.
• Bonds begin to drift higher on seemingly no news. Then company announces a $350M TL to monetize ATP Titan. Bonds continue to move higher.
• Rumors that the deepwater drilling ban will end early keeps the bonds moving higher still. Sell side starts to get bullish again - i.e. time to possibly lock in some gains.
• 2nd Telemark Hub begins production. Bonds and stock continue to climb.
• More rumors about the lift in the drilling moratorium. Bonds and stock climb further.
• Moratorium conditionally lifted - bonds go bid without (no sellers) in the mid 90s.

That takes us to about 2-3 weeks ago. There has been some positive and negative news since and bonds went out wrapped around 90 this afternoon.

During this entire timeline though, the company could have received at least $500M of assets for the Titan assets, had spent significant amounts of capital at both the Telemark and Gomez wells, had ~90MMbbl of Gulf of Mexico Reserves, and ~40M of North Sea Reserves, and nearly $300M of cash. Using sensible numbers, you could make a case for $2B for these assets vs. $1.65B of 1st lien and 2nd lien debt (before Titan monetization). Yes - you could have made the argument that GOM drilling was done for eternity, but then I would have called you crazy. It was a temporary problem that, yes, could have dragged on, but maybe to the detriment of $250M-$500M of ATP's value - still nearly covering the 2nd liens.

The above timeline shows you a typical distressed situation - sometimes they work out and other times they do not. As noted above and in previous posts, you have to compare how much your assets can be monetized for versus the claims against them. When the ATP bonds dropped to 70%, at market, there was about $1.2B of claims versus the aforementioned $2B of value - in my opinion, a pretty attractive margin of safety. If the moratorium had lasted into 2011, the company would have filed, and the bonds would have gone lower, but at the end of the day, the asset value would still be there and returns to the 2nd lien bonds may have been greater as they would have been the fulcrum security. Quite an interesting story indeed.

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Advanced Distressed Debt Lesson - Permitted Holders Carveout

Over the past week, many high yield and credit strategist put out a number of pieces on the recent rise of LBOs. What has driven this renewed interest in the LBO space? Lower cost of debt capital in the form of all time low yields across the B and BB space. While we have not seen LBOs like we did in the first half of 2007, conditions are ripe for a dramatic increase in the number of take private transactions for the rest of the year and into 2011 - especially if the Fed continues keep the curve at near all time historic lows.

With that said, high yield investors have started to review the indentures and credit agreements of current outstanding debt to understand better what would happen if a portfolio investment was taken over in an LBO or an MBO. In market parlance, the protection most investors seem to rely on is the change of control covenant or CoC. While the definitions of a change of control vary dramatically between indentures, a change of control covenant, all else being equal means that if XYZ company gets taken over, bondholders have the option to put the bond back to the company at 101.

Before I begin to dig into further details on CoC covenants, one interesting dynamic has created an interesting situation for bond investors. That is, because the treasury curve is so tight, many BB and B credits are trading well above 101. I do not have the statistic in front of me but I believe the average BB credit is trading around 105 right now. If there are no other covenants protecting you (outside a change of control), and an LBO goes forward, you are then faced with the choice of losing, on average, 4 points on your portfolio (105-101) or letting it ride in a now more levered, more speculative credit. Fun.

Getting back to the change of control covenant, as noted above, indentures vary dramatically between issuers and even in different bonds of the same issuer. For instance, in many cuspier investment grade credits, the change of control covenant may be worded that not only must their be a new ownership structure, but the company must also be downgraded to below IG by all rating agencies. From here, all sorts of legal ramifications and irregularities start to take hold. For instance, what if at the time of the takeover, one rating agency already had the company at below IG - then the "Change of Control Event" may not be fully satisfied according to the indenture and hence you are SOL.

With that said, one of the biggest carve outs under the change of control covenant you will see in indentures are the "Permitted Holders" carve outs. Let's look at some language to see what I am talking about here.

In August 2010, Expedia placed a 5.95% Senior Note due 2020. In the 8K announcing the deal, here is what the company had to say about change of control:

"The Company may redeem the notes, in whole or in part, at any time or from time to time at a specified make-whole premium. Upon the occurrence of a change of control triggering event (as defined in the Indenture), each holder of notes will have the right to require the Company to repurchase such holder’s notes, in whole or in part, at a purchase price in cash equal to 101% of the principal amount thereof, plus any accrued and unpaid interest to the date of purchase. The Indenture contains covenants limiting the Company’s ability and the Company’s subsidiaries’ ability to create certain liens, enter into sale and lease-back transactions, and consolidate or merge with, or convey, transfer or lease all or substantially all the Company’s assets to, another person. However, each of these covenants is subject to certain exceptions."

Unfortunately, 8k's mean nothing in the legal world. For the real juice, we need to look at the indenture (my emphasis added)

“Change of Control” means the occurrence of any of the following events:

(1) any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act), other than one or more Permitted Holders, is or becomes the “beneficial owner” (as defined in Rules 13d-3 and 13d-5 under the Exchange Act), directly or indirectly, of more than 50% of the total voting power of the Voting Stock of the Company;

(2) individuals who on the Issue Date constituted the Board of Directors of the Company (together with any new directors whose election by such Board of Directors or whose nomination for election by the shareholders of the Company was approved or ratified by a vote of a majority of the directors of the Company then still in office who were either directors on the Issue Date or whose election or nomination for election was previously so approved or ratified) cease for any reason to constitute a majority of the Board of Directors of the Company then in office;

(3) the adoption of a plan relating to the liquidation or dissolution of the Company; or

(4) the merger or consolidation of the Company with or into another Person or the merger of another Person with or into the Company, or the sale of all or substantially all the assets of the Company (determined on a consolidated basis) to another Person other than (i) a transaction in which the survivor or transferee is a Person that is controlled by the Permitted Holders or (ii) a transaction following which (A) in the case of a merger or consolidation transaction, holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such merger or consolidation transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of the surviving Person in such merger or consolidation transaction immediately after such transaction and (B) in the case of a sale of assets transaction, each transferee becomes an obligor in respect of the Notes and either (i) each transferee becomes a Subsidiary of the transferor of such assets or (ii) holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of the transferee.

Notwithstanding the foregoing, a transaction will not be deemed to involve a Change of Control if (1) the Company becomes a direct or indirect wholly-owned subsidiary (the “Sub Entity”) of a holding company and (2) holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such merger or consolidation transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of such holding company; provided that, upon the consummation of any such transaction, “Change of Control” shall thereafter include any Change of Control of any direct or indirect parent of the Sub Entity.

Look at the differences from the 8K to the actual indenture language. Specifically look at the clause "other than Permitted Holders" - let's dive back into the indenture and find the definition of "Permitted Holders:"

“Permitted Holders” means Barry Diller, Liberty Media Corporation and their respective affiliates and any group (as such term is used in Section 13(d) and 14(d) of the Exchange Act) with respect to which any such persons collectively exercise a majority of the voting power.

So even if the company gets taken over, but Barry Diller or Liberty Media are the "buying party" the change of control put would not be triggered. All else being equal, if Barry Diller or Liberty Media wanted to lever up Expedia in an LBO, bond holders would see their relative credit metrics weaken dramatically and consequently spreads would widen.

Sometimes in these cases bond holders are protected by negative pledge covenants as well as incurrence covenants. But given how structures and indentures have progressively gotten weaker over the past 18 months, bond holders have little protection when the permitted holders carve out allows for a credit negative LBO or MBO. Read those indentures to make sure you and your investors are protected as I expect to see many more LBOs in the coming months.

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