Residential investment: From distressed to investible again, like CZR
The below graph reflects something we haven’t seen in the four prior graphs in this series: residential fixed investment has actually shown a fairly significant improvement relative to corporate profits since 2012. While corporate profits as a percentage of residential fixed investment are still very high, at least they’ve fallen 25%—from 500% to 400% of total corporate profits. This is the best performance of all four sectors of fixed investment as covered in this series. This may still sound like more news that’s simply “less bad,” but this could be an important trend.
For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
The end of housing crisis helps big banks lend
While the above graph would suggest that the housing recovery is still quite weak—and it is—the good news is that at least the big banks have been able to clean up their balance sheets and recover their lending capacity. Plus, the big banks, and credit markets in general, are in a better position to engage in debt reductions, such as debt for equity swaps. In exchange for recognizing losses on fixed income investments, creditors can take a loss on re-negotiated bonds, and perhaps also receive a significant share of equity in the workout of a distressed situation.
To see how broad market indices are outperforming narrow market indices in equity markets, please see the next article in this series.
Caesar’s Entertainment: High yield credit exposure through diversified bank loan ETFs
Caesar’s Entertainment Corporation has a fairly small market capitalization of $3.57 billion and a CCC credit rating (below Sprint’s BB credit rating), the highest area of the below-investment-grade category. Reducing Caesar’s $21.54 billion of debt by the firm’s $1.71 billion cash position, we’re left with approximately $23.25 billion of net debt. In contrast to Verizon’s positive 9.54% profit margin and Sprint’s -8.5% profit margin, Caesar’s has a negative profit margin of -19.91%. Caesar’s revenues are $8.34 billion with an EBITDA of $1.76 billion to service its net debt of $23.25 billion, while Sprint has $5.47 billion to service debt of $25.5 billion. Meanwhile, Verizon has $48.57 of earnings before interest and taxes (EBITDA) to service its net debt of $42 billion. These differences in debt and EBITDA earnings drive the differences in credit quality ratings from the top-of-investment grade Verizon (BBB) to Sprint (BB) and Caesar’s (CCC).
The CC rated Caesar’s Entertainment’s (CZR) February 15, 2020, bond yields around 11.37%—much higher than the investment-grade Verizon’s (VZ) September 15, 2020, bond yielding 3.03%. BB rated below-investment-grade credits offer mid-range yield with Sprint’s (S) August 15, 2020, bond yielding 5.35%, Valeant’s (VRX) October 1, 2020, bond yielding 5.34%, T-Mobile US’ (TMUS) April 28, 2020, bond yielding 5.01%, and CIT Group’s (CIT) May 15, 2020, bond at 3.98%. For investors wary of credit risk, Verizon is a much safer investment grade bond, though the BB rated bonds offer a significantly higher yield (Bloomberg & Capital IQ, December 31, 2013, Quarter).
Short duration, higher credit risk: SNLN & BKLN
If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans, which offer a floating rate coupon based on short-term interest rate pricing—which is typically the 90-day interbank rate, known as “three-month LIBOR.” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London.)
Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration. The duration of these “floating rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate compared to corporate bonds—closer to 80% compared to closer to 50% in the case of similar rated bonds.
It’s important to note that both these ETFs invest in loans that are rated in the BBB-B area and they involve more risk of loss than portfolios rated in the AAA-A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8%, and BKLN around 4.95%.
Longer-duration, lower-credit-risk alternatives: AGG & LQD
If you’re wary of credit risk, you could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG). It maintains a duration of 5.11 years, though it has a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. Like LQD, AGG also holds high-quality commercial credits, such as Verizon (VZ)(0.09%) and GE Corporation (GE)(0.08%). Like SNLN, BKLN also holds lower-rated commercial credits, such as Fortescue Metals Group (FMG)(1.96%) and Valeant Pharmaceuticals (VRX)(1.48%). Note that the individual holdings of BKLN and SNLN are much larger than the holdings of the higher-credit-quality holdings of LQG and AGG, reflecting the greater diversification and the lower level of default-related losses associated with AGG and LQD.