Seek safety in senior debt

By Kanupriya Vashisht | May 16, 2014 | Last updated on May 16, 2014
5 min read

When he was younger, Jeff Sujitno thought the culinary world might be his calling. His architect father hoped he’d build great edifices. Instead, he fell into finance, starting his career 19 years ago with KPMG. A VP and portfolio manager at IA Clarington Investments Inc., Sujitno currently manages the IA Clarington Floating Rate Income Fund.

How do you choose your investments?

I invest in non-investment grade North American corporate debt securities. This means primarily senior secured floating-rate loans (70% of the fund) and high-yield corporate bonds.

Compared to fixed-rate debt instruments, senior loans offer higher yield and interest rate protection. Such funds invest in loans that banks make to non-investment grade companies, such as Heinz, Goodyear Tire and Dell. They offer higher starting yields (currently 5%) than government and corporate bonds. And, unlike standard high-yield funds, senior loans reset quarterly against a short-term benchmark (typically LIBOR in the U.S.), making them quite attractive in rising rate environments.

Another attractive feature of these loans is their seniority in instances of default or bankruptcy. They take priority for payback over nearly all other claims, and are almost always secured against a company’s physical assets, such as real estate and equipment. My bond exposure is currently just over 10% because there’s better relative value in loans at the moment.

How do you evaluate asset classes?

In the senior loan space, I prefer investing in the new issue market because those loans are almost always discounted. For example, I’m currently invested in the term loan for Salix Pharmaceuticals, which was offered at $99.50 and currently trades around $100.75. Similar to bonds, loans trade in the over-the-counter market.

A fundamental factor I look for is the borrower’s franchise value: whether the company matters to somebody—competitors, customers or suppliers. To determine franchise value, I look at the company’s profit margins. A company with strong margins relative to the industry can price its products and services at premiums. Margins vary by industry. A 15% EBITDA margin would be attractive for an industrial equipment distributor, but wouldn’t be for many software companies (their margins are higher). I also evaluate how important the company is to its customers. For example, we recently invested in a loan to a national distributor of pet supplies that generates higher profit margins than a typical distributor.

I further look for brand recognition and product or service uniqueness. For example, we invested in a term loan to a billing and payment provider in the healthcare sector that develops proprietary networks for service providers (hospitals, doctors, etc.) and insurers. This company acts as an intermediary, facilitating the enormous flow of billing and payments for medical procedures. The company has a powerful brand within the industry as it is the largest independent provider of these services.

Yet we’ve been struggling to find a good loan opportunity in the restaurant sector, given the immense competition and limited sustainable differentiation. We likely wouldn’t consider investing in a single-location restaurant, as it would not have scale and, as such, would not issue into the syndicated loan market. Several chains, including Burger King, Wendy’s, Arby’s and P.F. Chang’s, have tapped the syndicated loan market. We have not made an investment in these loans because we view pricing as too tight.

We do in-depth credit analysis on the issuer’s capital structure. We seek companies with recurring cash flows, experienced management, and debt obligations supported by a meaningful equity cushion. In conducting due diligence, we carefully examine the offering memorandum, audited financial statements, quality of earnings reports, rating reports and consultant reports. We focus on the credit and security agreements and the inter-creditor agreement, all of which prioritize secured lender rights. We also try to visit the company or attend management presentations about why the company needs financing.

When was the last time your investment process failed?

The hallmark of this asset class is its boring but predictable return profile—it’s generated a positive return in 21 of the last 22 years, according to index data.

The 2008 credit crisis impacted the loan world like all other asset classes. The Credit Suisse Leveraged Loan Index was down by about 29% as certain highly leveraged investors faced margin calls. But as soon as the selling pressure came off, the loan market snapped back because defaults were not as bad as spreads implied. In 2009, it was up by 44.9%.

We stayed the course in 2008 and ignored the market swings. We carefully monitored the financial performance of the companies we backed to ensure they could continue to service their debts.

That said, no matter how consistent and stable the returns in this asset class, there always are underlying risks. For example, in May 2012, we bought a loan on a new issue: one of the largest physiotherapy companies in the U.S. It traded up in the secondary market. We decided to sell the position and made a profit. Almost a year after we sold that position, the company unexpectedly missed an interest payment. We heard historical earnings may have been misstated and there may have been fraud. The company filed for Chapter 11 in the spring of 2013.

What’s catching your eye?

I like the retail space. We have a position in Neiman Marcus because we think its loan is priced more attractively—given the risk—than other available loans, such as Hudson’s Bay or J.C. Penny. We also have positions in niche retailers, such as fast-fashion clothier Charlotte Russe, because its consumers (young women) are spending.

When picking loans in the retail sector, we evaluate same-store sales, inventory turns, average ticket and store traffic. We also look at profitability, especially if retailers segment their lines. And one eye is always looking at macro fundamentals to make sure consumer confidence is still high and the market is still sound.

We also have a decent weight (16%) in information technology. We like software companies because many have predictable recurring revenue from long-term maintenance contracts. Large costs, like research and development and capital expenditures, are also controllable, resulting in more stable margins.

What circumstances would drive you to go all cash?

I can’t imagine a situation where we would have a high portion of the fund’s holdings in cash. Senior loans are at the top of an issuer’s capital structure, so they’re already relatively safe. Further, the fund is designed to clip coupons and generate interest income for investors.

We would increase our cash position should we see the market soften a little or inflows into the asset class taper off. In this situation, we would want to have capital available to deploy later at better value.

What are your short- and long-term risk controls?

We diversify and limit our concentration. We’re comfortable holding 70 to 100 names in the portfolio. One hundred names would mean, on average, we’re holding a 1% position. We wouldn’t be comfortable holding a position greater than 5% in the portfolio. We don’t want 500 to 600 names in our portfolio, either; you can’t generate as much alpha that way.

We also diversify and limit risk by way of industry or sector exposure. Our portfolio is currently distributed among 17 sectors, with the largest concentrations in information technology and healthcare.

Kanupriya Vashisht is a Toronto-based financial writer.

Kanupriya Vashisht