A Review of Leveraged Financial Markets, ed. Maxwell & Shenkman, pub. McGraw Hill

October 9, 2010

I have been greatly interested in junk bonds over my investment career, as they offer some potentially very attractive returns and often without correlation to the broader bond or equity markets. However, I have found that because junk bonds are considered as an asset class best left to the professionals, the literature available on them is small compared to the size of the asset class (particularly since the asset class grows during difficult economic times). Fortunately, though, in Leveraged Financial Markets, edited by William Maxwell & Mark Shenkman, we who are unafraid to build our own high yield portfolios have found a valuable resource. Whether we want to construct a full high yield portfolio, or just if we take my approach of buying single issues opportunistically, the book has much to assist us.

The book’s editors take the Frank Fabozzi approach, whereby instead of writing the book themselves, they solicited articles from experts in the particular field: the section on debt covenants was written by a partner at Cravath Swaine & Moore, a premier New York law firm, and other sections likewise written by experts in their fields.

One of the key pieces of advice is that it is impossible to make a portfolio that beats the target index under all circumstances. Certain types of bonds will do better in a recession, and other types of securities will do better in a neutral or growth situation, and because of the liquidity in the bond markets it is impossible to switch one’s approach without incurring greater costs than the profits from the new approach. This is common sense, but it puts me in mind of my own value investing approach. The goal of an investor, professional or personal, should not be to beat an index; it should be to finish up with more money than we start with, without taking undue risks. And, as I stated above, those of us who invest for ourselves have our choice of asset classes and can act opportunistically, as opposed to someone constrained to run a junk bond portfolio, have the advantage in this situation.

In terms of actual analysis, they provide some very useful advice, the most important of which is to adopt a highly fundamentals-based approach and above all not to rely on credit ratings. Even before ratings agencies had to back away from the ratings they issued because of the tsunami of CMO defaults, they have taken great pains to remind users that, although a BBB credit is better than BB, they cannot translate a rating to a default probability. Although the book refers us to a number of services that perform statistical analyses to identify defaults before they happen, my preferred approach is to find junk bonds that are actually robust to defaults. At any rate, the authors also remind us of concerns broader than default risk of a single issue, such as the health of the sector and also the level of liquidity in the market. At any rate, the key advice of the book is to analyze credits yourself, rather than rely on a credit rating agency to do it. This is vital advice; my favorite credit rating seems to be CCC+, and although most CCC+ bonds I can still reject as unsuitable, I would throw away a whole family of B rated bonds to find a CCC that offered the right risk/reward situation. The authors also remind us that a high yield cannot compensate for unpalatable risk; a junk bond investor cannot afford to assume that his or her portfolio holdings insure each other.

I have to say that my faorite part, though, was the discussion of covenants, and not just because it was written by a lawyer. Covenants are not even mentioned in Graham’s Security Analysis, since prior to the 80s deep consideration was deemed unnecessary because only creditworthy companies were expected to issue debts anyway. And, of course, before the junk bond crash of the early 90s no one quite grasped their importance. Afterwards, the bond community decided that it was necessary to take covenants beyond their historical course. As the book details, junk bond covenants are now greatly detailed, including restrictions on use of loan proceeds, restrictions on issuing new debt and even interest coverage ratios, in order to protect holders from small problems becoming large problems leading to bankruptcy. In fact, my short recommendation on SBA Communications was largely based on the possible impending breach of their covenants.

In short, anyone who is interested in junk debt, or even companies that issue it, would do well to have a resource like this one at their disposal.

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